journal 12/2
00
4/#
12
the journaloffinancialtransformation
Emerging models
Transition
Future
Payments
Recipient of the APEX Awards for Publication Excellence 2002-2004
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Editor
Shahin Shojai,DirectorofStrategicResearch,Capco
Advisory Editors
Predrag Dizdarevic,Partner,Capco
Bill Irving,President,Capco
John Owen,Partner,Capco
Editorial BoardFranklin Allen,NipponLifeProfessorofFinance,TheWhartonSchool,UniversityofPennsylvaniaJoe Anastasio,CEO,CrossBorderExchange,andPartner,CapcoPhilippe d’Arvisenet,GroupChiefEconomist,BNPParibasJacques Attali,Chairman,PlaNetFinanceRudi Bogni,FormerChiefExecutiveOfficer,UBSPrivateBankingBruno Bonati,MemberoftheExecutiveBoardandDivisionHeadTechnology&Operations,CreditSuisseFinancialServicesDavid Clark,NEDontheboardoffinancialinstitutionsandaformersenioradvisortotheFSAGéry Daeninck,formerCEO,RobecoDouglas W. Diamond,MertonH.MillerDistinguishedServiceProfessorofFinance,GraduateSchoolofBusiness,UniversityofChicagoElroy Dimson,ProfessorofFinance,LondonBusinessSchoolNicholas Economides,ProfessorofEconomics,LeonardN.SternSchoolofBusiness,NewYorkUniversityMichael Enthoven,ChiefExecutiveOfficer,NIBCapitalBankN.V.José Luis Escrivá,GroupChiefEconomist,GrupoBBVAGeorge Feiger,ExecutiveVicePresidentandHeadofWealthManagement,ZionsBancorporationGregorio de Felice,GroupChiefEconomist,BancaIntesaWilfried Hauck,ChiefExecutiveOfficer,AllianzDresdnerAssetManagementInternationalGmbHThomas Kloet,SeniorExecutiveVice-President&ChiefOperatingOfficer,FimatUSA,Inc.Herwig Langohr,ProfessorofFinanceandBanking,INSEADMitchel Lenson,GlobalHeadofOperations&Technology,DeutscheBankGroupDavid Lester,ChiefInformationOfficer,TheLondonStockExchangeDonald A. Marchand,ProfessorofStrategyandInformationManagement,IMDandChairmanandPresidentofenterpriseIQ®
Colin Mayer,PeterMooresProfessorofManagementStudies,SaïdBusinessSchool,OxfordUniversityRobert J. McGrail,ChairmanoftheBoard,OmgeoJeremy Peat,GroupChiefEconomist,TheRoyalBankofScotlandJos Schmitt,Partner,CapcoKate Sullivan,ChiefOperatingOfficer,e-CitiJohn Taysom,Founder&JointCEO,TheReutersGreenhouseFundGraham Vickery,HeadofInformationEconomyUnit,OECDNorbert Walter,GroupChiefEconomist,DeutscheBankGroupDavid Weymouth,ChiefInformationOfficer,BarclaysPlc
TABlE oF conTEnTs
noBEl lAuREATE ViEw
6 nash’s theories and their impact on economics and financeAdiscussionwithProf.JohnF.NashJr.,SeniorResearchMathematician,DepartmentofMathematics,PrincetonUniversity,andJoint-WinnerofTheBankofSwedenPrizeinEconomicSciencesinMemoryofAlfredNobel1994
EmERging modEls
12 opinion: Bringing broadband banking to iraqKathleenTyson-Quah,ChiefExecutive,GranularityLtd
16 opinion: unifying the European payments landscapePhilippeMenier,ChiefOperatingOfficer,VisaEuropeLtd
21 opinion: credit card security on the net: where is it today?SankarsonBanerjee,SeniorArchitect,Mphasis
24 opinion: Broadening the value proposition around payments outsourcingThomasHalpin,VicePresident,JPMorganTreasuryServices
26 opinion: Bringing payments togetherMichelAkkermans,ChairmanandCEO,Clear2Pay
31 Payment systems and regulationHansGeiger,Professor,TheSwissBankingInstitute,UniversityofZurichFritzKlein,IndependentConsultant,andChairman,CLSHoldings/CLSBankInternational
39 why has stored-value not caught on?SujitChakravorti,SeniorEconomist,FederalReserveBankofChicago
49 online payments systems for e-commerceCarolinePaunov,Consultant,OECDGrahamVickery,HeadoftheInformationEconomyUnit,OECD
55 six smart moves when playing the smart card gameLeoVanHove,AssistantProfessorofEconomics,VrijeUniversiteitBrussel(FreeUniversityofBrussels)
TRAnsiTion
64 opinion: Payments policy in the information ageRonaldJ.Mann,BenH.&KittyKingPowellChairinLaw,Co-Director,CenterforLaw,Business&Economics,TheUniversityofTexasSchoolofLaw
68 opinion: creating a profitable infrastructure — The payments challenge for banks AnnCairns,GlobalHead,WorkingCapital,ABNAMRO
71 opinion: Payments in transition: where have all the changes gone?MarkWebster,Partner,Capco
74 opinion: Electronic payments: The drive towards a competitive, customer service driven utilityRodDew,MarketingDirector,DistraPtyLtd
79 simulation: A powerful research tool in payment and settlement systemsHarryLeinonen,AdvisertotheBoard,BankofFinlandKimmoSoramäki,PolicyExpert,EuropeanCentralBank
85 European payment systems and monetary unionFranciscoJ.CalladoMuñoz,AssistantProfessor,UniversityofGironaNataliaUtreroGonzález,VisitingProfessor,UniversitatAutonomadeBarcelona
93 Technological innovation in retail payments: Key developments and implications for banksKarenFurst,PolicyAnalyst,OfficeoftheComptrolleroftheCurrencyDanielE.Nolle,SeniorFinancialEconomist,OfficeoftheComptrolleroftheCurrency
FuTuRE
104 opinion: innovation on networks: coordination, governance, and the case of VisAMatthewCardillo,AssistantEconomist,FederalReserveBankofKansasCityAntoineMartin,Economist,FederalReserveBankofKansasCityMichaelJ.Orlando,SeniorEconomist,FederalReserveBankofKansasCity
108 opinion: The evolution of currencyJamesTurk,founder,GoldMoney.com
110 opinion: Automating payment processes to reduce working capital KurtCavano,ChairmanandCEO,TradeCard
112 opinion: new agenda for payment service providersTerryDirienzo,Director,GroupPayments&Settlements,BarclaysPlc.MarkHale,HeadofPaymentsStrategy,GroupPayments&Settlements,BarclaysPlc.
116 opinion: new models of collaboration in transaction bankingWolfgangGaertner,ChiefInformationOfficer,GlobalBankingDivision-GlobalTransactionBanking,DeutscheBank,and,Director,SWIFT
120 opinion: European payment service providers: A race to market and the nature of future victory?JulianWakeham,Partner,CapcoAndrewHogan,ManagingPrincipal,CapcoHectorNelson,Consultant,Capco
125 network-based payments and e-settlementHarryLeinonen,AdvisertotheBoard,BankofFinland
131 Banks’ strategies for payment services: which role for debit cards?FrancescoSaita,AssociateProfessor,FinancialMarketsandInstitutionsDepartment,UniversitàBocconi
141 delivering migrant workers’ remittancesRogerBallard,Director,CentreforAppliedSouthAsianStudies,UniversityofManchester
155 check 21 and the migration to electronic paymentsAdamDener,Partner,Capco
Overlookedandignoredforyears—ifnotdecades—atatime,thepaymentsindustryhasbeeninaconstant
stateoffluxasoflate.Paymentsservicesproviders,suchasuniversalbanks,havehadtocopewiththenotion
thatabusinesspossiblygeneratinghandsomereturnshasnowmoreoftenthannotbecomeacostcenter.In
myopinionthereis,therefore,nobettermomenttodedicateanentireissueoftheJournaltopaymentsinall
itsfacets.
Aswithallother transitions in the financial servicessector,change in thepayments industry isaglobal
phenomenonwithlocalorregionalflavoring:InEuropetheintroductionofthesinglecurrencyaslegaltender
in2002wasimmediatelyfollowedbyadecreeforcingpaymentsserviceproviderstoequalizethecostborne
byusersofmakingacross-bordereuropaymenttothecostofmakingadomesticeuropayment:zero.The
customofpaper-checkpayment intheUnitedStates—abusinessestimatedtogenerateU.S$25billion in
customersupportaccountfeesandU.S.$34billionindeposit/floatfees—isonacontinuedcourseofchange
toelectronictransactionprocessing,enhancedbytheCheckClearingforthe21stCenturyAct.Asia’svarious
developedandestablishedeconomiesseean increasedpresenceofcreditanddebitcardprovidersasan
alternativetocashpayments,and‘secondary’paymentssystemsusedbymigrantworkerstosendfundsback
home.
Thesedevelopmentshelpdramaticallychangepayments’traditionallowvisibilityandstrategicimportancein
banks,andensurethatthecostimplicationsofmaintainingapaymentscapabilityin-houseandthevalueof
theannuityrevenuetheydevelopbecomeincreasinglyrecognizedasimportant.Conceptswhichsincemany
yearshavedominatedtheagendaofsecuritiestradingandprocessingproviders—sharedservicecenters,
outsourcingandoff-shoring,tonamebutafew—arenowalsofirmlycaughtintheimmediateattentionspan
of many payments providers, often piggybacking on previous experience obtained in the financial instru-
mentsdomain.
InthisJournalIwouldliketodrawyourattentioninparticulartotheTransitionsection,whereanumberof
operationalplaysforpaymentsservicesprovidersareshowcased.AtCapcowehavebenefitedgreatlyfrom
ourinfrastructureprojectworkforrespectedproviderstofurtherourthinkingaboutthefutureofthepay-
mentsindustry.Itrustthatyouwillfindthiseditionofouraward-winningpublicationinspiringforyourown
insightanddecisionmakingprocesswhenfacingpaymentschallenges.Enjoy!
RobHeyvaert,
Founder,ChairmanandCEO,Capco
Payments finally hits the boardroom table
It is quite remarkable how payments, be they instruments or mechanisms, are generally viewed, even by
financialinstitutions,asnothingmorethanameanstoanend.Aservicethatneedstoexistinordertomake
sureindividualsandinstitutionsareabletopayforthegoodsandservicestheypurchasefromoneanother.
Itis,ifyouwill,thenotsoexcitingpartofthebusiness.Thebitthathappenswhenalltheotherexcitingevents
havetakenplace.Consequently,paymentsserviceproviders,betheybanksorotherthird-partyinstitutions,
haveallto loseandnotmuchtogain. Ifthetransactionsaresettledsmoothlythenthemechanismshave
donetheirjob,butifthereisanydelayorproblems,theyhavefailedinthissimpletask.But,howsimpleis
thistask?
Basedonthearticlesinthisissue,itisnomeantasktomakesureindividualsandorganizationswhoknow
littleabouteachothercanmakepaymentstooneanother.Thearticlesinthisissuealsohighlightthefact
thatittakesmorethansmarttechnologiesandgoodwillfromfinancialinstitutionstomakeanewpayment
mechanismwork.Wewillfindoutwhyindividualandinstitutionalbehaviorscanmakeorbreaknewpayments
instrumentsormechanisms.And,moreinterestingly,whydespitethefactthatpaymentsareoftremendous
importancetofinancialinstitutions,intermsofcostsandrevenues,theyremainsofarbelowtheradaroftop
managementandstrategists.
However,beforewediscussthecontentsofthethreesectionsthatmakeupthis issueoftheJournal,we
wouldliketoexpressourtremendousexcitement,pride,andhonoratthefactthattheNobelLaureateView
forthisissuehasbeenkindlyprovidedbyProf.JohnNashJr.ofPrincetonUniversity.
Insectionone,wefocusonthetopicofemergingpaymentsmodels.Herewelookatthenewpaymentinstru-
mentsandmechanismsthathavebeenintroducedanddiscusswhysomehavebeenmoresuccessfulthan
others.Theauthorsdescribehownewpaymentmethods,suchasdebit,creditand,smartcards,areaiming
tohelp individuals improvethewaytheymanagetheirfinancesandmakethewholeprocessofpayments
moreefficient.Theyalsoexplainhowcardpaymentstechnologiesarenotonlyprovidinguswithguidanceon
howtomakeourcurrentpaymentmethodsmoreefficient,buthowtheycanbeessentialwhencreatinga
wholenewbankingsystemforawar-torncountry,suchasIraq.
Section two discusses how payment systems have evolved in recent years. The authors look at the chal-
lengesfacedbythebankingsectorinimprovingtheefficiencyofpaymentsprocessesandexplainhowthey
were able to overcome them. This section also covers how simulation tools can help test new payment
mechanismswithoutbringingthewholepaymentssystemundertheriskoffailure.Sectionthreelooksatthe
futureofpayments, includingnewpayments toolsandmethodologies.Thearticlesexamine thepotential
benefitsoffocusingonthoseareasinwhichbankshavespecificcorecompetenciesandhowoutsourcingto
otherbanksorthird-partyproviderscanhelpinthateffort.Thelonglistofnewregulationsintroducedhas
dramaticallyincreasedthecostofbeinginthisspace,andthepapersinthissectionlookatwhatoptionsare
opentobanksfacingthem.
Wehopethatwehaveachievedourobjectiveofprovidingathoroughreviewofthemajorissuesimpacting
thepaymentsworld.Wealsohopethatyouenjoyreadingthisissueandcontinuetosupportthejournalby
submittingyourbestideastous.
Onbehalfoftheboardofeditors
making payments work
8 - The Journal of financial transformation
THE NOBEL LAuREATE VIEW
nash’s theories and their impact on economics and financeA discussion with Prof. John nash, Jr.Senior Research Mathematician, Department of Mathematics, Princeton university, and Joint-Winner of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1994
Weareveryhonored thatJohnNash,Jr., themancredited
withoneofthemostprofoundcontributionstotheworldof
economics,haskindlytakenthetimetohelpusgetabetter
understandingofhistheoriesandhowtheyapplytotheworld
ofeconomics.Below,youwillfindthequestionsposedandthe
answerskindlyprovidedbyProf.Nash.
understanding of the theoriesQ: One of the most interesting facts about economic theo-
ries that I have come across is the number of people, includ-
ing myself, who feel that they have a good understanding of
a given theory when in reality they do not. Do you believe
that most people who refer to your theories fully under-
stand them?
Prof. Nash: No, indeed, the majority — even, say, among
economists—wouldhaveonlyanincompleteor‘casual’famil-
iaritywithmycontributions.
NowI justhappentothinkofaverygoodreferencesource;
thisisthebook‘EssaysonGameTheory’publishedbyEdward
Elgar(aBritishpublisherspecializingineconomicsandrelat-
ed fields). Elgar contacted me about publishing a book like
this soonafter thenewsofmyNobelLaureate recognition.
Thisbookhaseverythingthatwaspublishedduringthetime
ofmystudiesinthe50’sinamajorpublication.
Q: Of course, many of our readers either do not have the
time to read that book or will have a tough time understand-
ing its complexities. In order to help our readers get a better
understanding of your theories can you kindly describe your
biggest contribution in a sentence or two?
Prof. Nash: It is not, really, a meaningful issue of whatever
might seem to be my ‘biggest contribution’, when learning
andcultureareviewedfromsometimemuchfurtherintothe
future.Rightnow,Icanonlygowithconventionalopinionand
suggestsimplyaquotationofthecitationatthetimeofthe
Nobelceremonieson10December1994.
Q: Is that a quotation from your own speech at the awards
ceremony?
Prof. Nash:No,thereisamisconceptionhere!Thefactisthat,
quiteexceptionally, Ididnotgivea lecture inStockholmon
the occasion of my being awarded the prize (with Harsanyi
andSelten).Instead,Prof.HaroldKuhn,ofPrincetonUniversity,
gave a lecture about the work I had done which was being
recognizedandaboutconnectionsandapplications,etc.This
organizationalformatwasarrangedbecauseIhadnotbeen,
formanyyearspriorto1994,actuallystudyingandworkingin
economics and game theory. And this circumstance was
relatedtomyhistoryofhavingbeenunder‘mentalillness’for
manyyears,althoughatthattime,in1994,Icouldhave,well
enough,givenalecturemyself,ifthathadbeenrequested.So
whileinSwedenIgavealectureatUppsalabutthiswasnot
ongametheoryoroneconomics.Inyearssubsequentto1994
and1995Ihavebeen,again,activelystudyingintheseareas,
withnewresearchprojects.
Q: In order to help our readers get a better understanding of
Prof. Nash’s contribution, we will use three quotes from the
panel chaired by Prof. Kuhn in honor of Prof. Nash’s Nobel
Prize in Sweden.
‘Nashprovedbypage6ofhisthesisthateveryn-personfinite
non-cooperative game has at least one (Nash) equilibrium
point.Thisisaprofileofmixedstrategies,oneforeachplayer,
whichissuchthatnoplayercanimprovehispayoffbychang-
inghismixedstrategyunilaterally.’Kuhn(1994)1
‘[The Nash] equilibrium is without doubt the single game
theoreticsolutionconceptthatismostfrequentlyappliedin
economics. Economic applications include oligopoly, entry
and exit, market equilibrium, search, location, bargaining,
product quality, auctions, insurance, principal-agent [prob-
lems], higher education, discrimination, public goods, what
haveyou.On thepolitical front,applications includevoting,
arms control and inspection, as well as most international
political models (deterrence, etc.). Biological applications all
1 Kuhn,H.W.,1994,“NobelSeminarinhonoroftheworkofJohnNashinGame
Theory,”December8
9
deal with forms of strategic equilibrium; they suggest an
interpretation of equilibrium quite different from the usual
overtrationalism.Wecannotevenbegintosurveyallofthis
literaturehere.’
Aumann(1987)2
‘Intheshortperiodof1950-53,JohnNashpublishedfourbril-
liantpapers3,inwhichhemadeatleastthreefundamentally
importantcontributionstogametheory:
1. Heintroducedthedistinctionbetweencooperativeand
non-cooperativegames.Theformeraregamesinwhich
theplayerscanmakeenforceableagreementsandcan
alsomakeirrevocablethreatstootherplayers.Thatisto
say,theycanfullycommitthemselvestospecificstrate-
gies.Incontrast,innon-cooperativegames,suchself-com-
mitmentisnotpossible.(Actually,Nashalsoassumedthat
inanon-cooperativegame,theplayerswillbeunableto
communicatewitheachother.Yet,inmyownview,this
wouldbeaneedlesslyrestrictiveassumption.Forifthe
playerscannotenterintoenforceableagreements,then
theirabilitytocommunicatewillbeofnorealhelptoward
acooperativeoutcome.)
2.Asanaturalsolutionconceptfornon-cooperativegames,
heintroducedtheconceptofequilibriumpoints,nowusu-
allydescribedasNashequilibria.Healsoestablishedtheir
existenceinallfinitegames.(NotethatNashequilibria
seemtobetheonlysolutionconceptapplyingbothto
gamesinnormalformandinextensiveform.)
3. Asasolutionconceptfortwo-personcooperativegames,
heproposedtheNashbargainingsolution,firstforgames
withfixedthreats,andlateralsoforgameswithvariable
threats.Healsoshowedthat,inthelattercase,thetwo
players’optimalstrategieswillhavemaximinandminimax
properties.
‘ThebestwaytounderstandtheimportanceofNash’scontri-
butions isbycomparingthestateofgametheory justafter
publicationofVonNeumannandMorgenstern’sbookin1944
withitsstateafterpublicationofNash’sfourpapersin1953.
VonNeumannandMorgenstern’sbookcontainsanexcellent
mathematicalanalysisofoneclassofnon-cooperativegames,
viz.oftwo-personzero-sumgamesandoftheminimaxsolu-
tionforsuchgames.Itcontainsalsoanexcellentmathemati-
cal discussion of one cooperative solution concept, that of
stablesets,formanyspecificgames.Yet,itsohappensthat
theconceptoftwo-personzero-sumgameshasveryfewreal-
lifeapplicationsoutsideofthemilitaryfield.Theconceptof
stablesetshasevenfewerempiricalapplications.
‘Had these twodistinguishedauthorshadNash’snotionsof
cooperative and non-cooperative games available to them,
thenpresumablytheywouldhaveaskedthequestionofhow
toact rationally ina two-personnonzero-sumgameor ina
more-than-two-persongameifthisisplayedasanon-cooper-
ative game, permitting no enforceable agreements and no
irrevocable threats. Perhaps they would have asked also
whether one could not find for cooperative games a more
convincingsolutionconceptthanstablesetsare.Forinstance,
whetheronecouldnotfindasolutionconceptyieldingsharp-
er-predictions about the players’ actual payoffs than the
conceptofstablesetsdoes.’Harsanyi(1994)4
impact on financial marketsEconomistsviewthemarkets,inspecificstockmarkets,tobe
efficient,oneofthemaincomponentsofwhichbeingperfect
competition and perfect dissemination of information, such
thatnoonecanusetheirknowledgetogainsuperiorreturns.
Q: You suggest that transactions fail not necessarily because
participants behave irrationally, but because they do not
know each other’s perspectives of the transaction (i.e. what
is the highest price they are willing to buy at or the lowest
price they will sell at). Does this mean that better informa-
tion can help increase the likelihood of transactions?
Prof. Nash:I,personally,didnotspecificallysuggestthis.But
thisphenomenonisaveryrealandrecognizedone.Recently
the theme of an (economics) Nobel Prize award (shared by
threeAmericans)was‘asymmetricinformation’representing
2 Aumann,R.J.1987,“Gametheory,InThenewPalgraveDictionaryofEconomics,”
editedbyMilgate,M.andP.Newman,460-482.Thisquotewasextractedfromthe
introductoryspeechgivenbyProf.Kuhnatthe1994NobelPrizeseminar.
3 Nash,Jr.,JohnF.,1950a,“Equilibriumpointsinn-persongames,”Proceedings
NationalAcademyofSciences,36,48-49
Nash,Jr.,JohnF.,1950b,“Thebargainingproblem,”Econometrica,18,155-162
Nash,Jr.,JohnF.,1951,“Non-cooperativegames,”AnnalsofMathematics,54,
286-295
Nash,Jr.,JohnF.,1953,“Two-personcooperativegames,”Econometrica,21,
128-140
4 Harsanyi,J.C.,1994,NobelSeminarinhonoroftheworkofJohnNashinGame
Theory,December8
decisionsofanindividualnegotiant.Learningisgoodingen-
eral,theinteractionofspeculatorsandinvestorsis(ofcourse)
game-like,butbeyondthattruismthelevelofpracticalutility
maynotbeeasilyreached.
Q: Can your theories be used to help in determining man-
agement compensation in the u.S., which seems to be going
through the roof?
Prof. Nash:Itis,indeed,aphenomenon.But,gametheoreti-
cally,thereishardlyanyreasonablelimitontheappropriate
compensation for a valuable executive. If Henry Ford, the
founder,deservedtoownthecompany,thenatalatertime,
BillFord,adescendantandnowchiefexecutive(ifanygood
atthatfunction!),mightmeritacomparablelevelofcompen-
sation.Andthere is thegeneralphenomenonof theappar-
ently increasing disparity of incomes and prosperity. One
thingtothinkaboutistheincreasingfactorofmultiplication
applicabletothelaborofafewpersons.Anactoronastage
canbeseenonlybythoseinanaudiencewithinhearingdis-
tance.AnactorinaTVseriescanbeseenandheardbymil-
lionsateachperformance.
PaymentsThethemeofthisissueispayments.Oneofthebiggestprob-
lems that exist in the world today is the lack of trust that
existsbetweenmarketparticipants.Hencetheneedforthe
establishmentofevermoresecuretransactions.
Q: On payments, the inability to know about the motivations
and situations of many individual participants led to the
creation of exchanges and other mechanisms for central
assumption of accountability for completion of transac-
tions. The cost of learning the situation of participants is
often so high that other structures are created to reduce
the need to know. You could look at DVP as being refusal to
learn anything: just pay me when I pay you and life is sim-
ple. Can non-cooperative game theory suggest a way to
improve the way organizations make payments to one
another?
Prof. Nash:Iguessitmusthavebeenalongtimeagothatthe
stockbrokerwasinvented.Andthroughthemoccurpurchase
and sale transactions between parties that would be quite
naturallyveryuntrustingofeachother. Iwouldnotwantto
claimanymagicalpotencyofgametheoryhere,butofcourse
itisnaturallyappropriatefortheconsiderationofsituations
wheretherearepartiesthathaveintereststhatarenotsim-
plyparallel.
Q: Would it help reduce the costs involved in international
transactions?
Prof. Nash:Ifeelthatthecostsofinternationaltransactions
aretypically‘whatthemarketwillbear’.Notlongagoitwas
costlytochangeItalianliramoneyintoFrenchfrancsandvice
versaanda touristcouldpayouta lot thatwayonashort
vacation.Now,with theeuro thatparticularcost isentirely
gone!Telephonechargeshavealsotypicallybeen ‘whatthe
marketwillbear’ratherthanamountsactuallydirectlyrelat-
edtocostscalculableintermsofthetechnology.
world tradeFoundingfathersofeconomicshavesuggestedthatincertain
circumstancesevenifthecostofproductionofoneproduct
ishigherinagivenmarketitmightstillmakemoresensefor
that product to be made in that location if the cost of
exchangeintootherproductsislowerthaninothermarkets.
Q: Can you explain why it is that most countries are still
trying so hard to produce everything?
Prof. Nash:Thereisoftensimplyanationaldefenseconcept.
The Japanese perhaps would feel themselves to be in an
unfortunatesituationiftheycametoactuallygrownoriceat
allwithallriceconsumedbeingimported.
Q: Do you believe that your theories can help improve the
productivity of the world we live in?
10 - The Journal of financial transformation
the themeofhowonepartymightbebetter (ordifferently)
informedthananother.Andthis,ofcourse,initselfimpliesthe
importance of imperfections of information. The issues of
completenessorincompletenessofinformationareoldtopics
ingametheory.
Q: Can your theory also work when you are dealing with
thousands of participants? Can we really have behavioral
information about so many participants, or do we, can we,
segregate them into groups to make this more viable?
Prof. Nash:Mostdefinitelyyes!Thatis,the‘non-cooperative
game’ concept was always, as I could see immediately, well
suited for application to the multitude of speculators and
investorsthatmightbetradinginthesharesofMSFTonthe
stockexchanges.Yousee,theseindividualtradersareallact-
ing‘incoherently’.
Q: Can the determination of other participants’ values of a
transaction be helpful in increasing the returns we generate
from our transactions (i.e. are the people who are able to
master this able to consistently achieve better rates)?
Prof. Nash:Fromthecompetitivepointofviewitisgenerally
desirabletohavemorerelevantinformation.Fromthecoop-
erativepointofviewitcanalsoimprovemutualbenefitsfor
thepartiestohavemoreinformationaboutthemselves.There
can be paradoxes, however, which can be revealed through
gametheory.IwassurprisedrecentlywhenIwasatagame
theorymeetingand Ihearda talk inwhichanexamplewas
presentedofanauctionsituation,viewedthroughgametheo-
ry, and it turned out that if two bidders in the auction had
different amounts of information about the quality of the
product being sold at auction that it could happen that the
bidderwith less informationwould realize thehigherpayoff
result! IwasquitesurprisedwhenIheardthisandIthought
aboutitinrelationtonon-cooperativegametheory.Andthen
Icouldseethatitwasconsistent.Thenafriendconfirmedthat
itwasafamiliaroccurrenceinexamples.Thethingisthatthe
twobidders, intheauctiongame,arenotsimplyopponents,
oneoftheother,theyarebothcontendingwiththeauction-
eer.
Q: Consequently, are you suggesting that investors/traders
should spend more time determining what the most efficient
level of negotiation would be?
Prof. Nash: Well, first of all, the concept of a ‘minmax’ or
‘minimax’ isaconceptrelatingtozero-sumgamesandthus
properlyrelatingtogamesoftwoplayerswithdirectlyoppos-
inginterests.Thisisnotreallytherelevantcontextforinves-
tors, because all investors can gain, in principle, with good
investments,orallcouldlose,inagreatbubbleoftulipsorof
dotcoms. When the games of speculators can properly be
seenasessentiallyofzero-sumcharacter,withwealthmerely
being transferred but never created, then still the minmax
concept is not of use because these speculative games are
many-person in character (or even games of multitudes)
ratherthangamesoftwoparties.Andnowasidefromminmax
issuesbutrelatingtogametheoryingeneralIcanmakethe
generalremarkthatatheorycanbequitevaluableevenifit
doesnotgiveexplicitlyuseful informationtothepersonsof
the classes to which it would seem to directly apply. Thus
game theory is not very helpful to chess players. And the
medical and physiological theory of muscle functions and
healthwouldnotdirectlyhelpanathlete toprepare for the
Olympics. A player in games or a businessman or financier
may,realistically,needtousetherelevantschoolofcommon
sensetoplaywell,whilegametheoristsmaybeabletoeffec-
tivelyanalyzethebehaviorofclassesofsuchplayers.
J.P.Morgansaiditall,inasense:‘Buylow,sellhigh.’Andthis
isperfectlyvalid,althoughsomewhattautological.
The ‘negotiant’ cannot usually rationally assume that other
negotiantsareplayingaccordingtosomesortofagame-the-
oreticallybasedstrategy.Ifthereisa‘market’thentheadvice
ofMorganisrelevantasaguide.Soagame-theoreticanalysis
basedonwhatotherswouldbedoingiftheywereoperating
according to a game equilibrium (or some other game con-
cept)mightnotbewelljustified,inanindividualcaseforthe
11
Prof. Nash:Itwouldnotbeadirecteffectiftherewouldbea
benefit.WhatIcanseeisthatglobalcooperationinartsand
sciences will naturally increase the economically measured
‘productivity’concepts.
Q: Many suggest that your theories could be used to help
protect the environment in a way that benefits all. Why do
you feel it has not been fully utilized?
Prof. Nash: At the meeting in Marseilles devoted to game
theorywhichIattendedinearlyJuly2004Isawaposterby
aJapanese theorist relating to theKyotoprotocolsand the
themeofglobalwarming.Thethemewasdevelopedinterms
ofcooperativetheorybutasIthoughtaboutitIfeltthatthere
wouldbeamajor issuederivingfromthepossibilityofnon-
cooperativebehaviorbynationswithdifferentnatural inter-
ests.Perhapsingeneral,theenvironment,asaninterestofall
humans, can be most favorably or most easily protected by
concertedhumanactionsandplanningifthereisanappropri-
ateandgoodlevelofcooperationoftheworlddirectedtothat
objective.Globalcooperation,itself,isanaturaltopicforgame
theoreticstudies.
Q: Prof. Nash, thank you very much for giving us this time.
We hope that our readers have benefited from your insight.
12 - The Journal of financial transformation
Emerging models
Bringing broadband banking to iraq
unifying the European payments landscape
credit card security on the net: where is it today?
Broadening the value proposition around payments outsourcing
Bringing payments together
Payment systems and regulation
why has stored-value not caught on?
online payments systems for e-commerce
six smart moves when playing the smart card game
Bringing broadband banking to iraqKathleen Tyson-QuahChief Executive, Granularity Ltd
salesexecutiveconfirmedtheirsuccessfuluseofR-BGANin
three banking installations in Africa and the Middle East. In
responsetomyinquirysheletmeknowthatNSSLwasthen
supporting solutions to several clients operating in Iraq. At
thispointIaskedwhetherNSSLwouldliketobuildabanking
networkat80locationsinIraq.Afteralongpause,shesug-
gested that she would arrange a conference call with col-
leagues.NSSLhassinceconfirmedthataninternaldebateon
whetherIwastoocrazytobetakenseriouslyoccurredprior
totheconferencecall.
Imusthaveacquittedmyself rationallyon thecall, because
fromthatdateNSSLwasonmyteam.Theyjustifiedmycon-
fidence in their project management skills by coming back
with a project specification and initial quotation for an
80-nodenetworkwithin48hours.
Because NSSL was already operating within Iraq, they were
abletosimplifymanyofthelogisticschallenges.Theyagreed
to take responsibility for procurement, configuration, and
deploymentofthelaptopPCsaswellason-siteinstallationof
thesatellitemodems.Theirexistinghelpdeskoperationsand
Baghdad-basedengineerswouldhandlealldownstreamsup-
port. NSSL would later assume responsibility for in-country
trainingofhundredsofbankstaffwhohadneverbeforeseen
acomputermouseorusedMicrosoftapplications,andalsofor
hostingtheCentralBankofIraqwebsite.
Mammoth mainframes spring to mind when payments are
discussed among central bankers — not laptop PCs. Massive
securityandresiliencytosafeguardtheintegrityofthepay-
mentsprocessandpaymentsdataareessential.Laptopsare
viewed as inherently risky and insecure. I have read every
Basle Committee report on payment systems and knew all
this, but in Iraq it seemed tome that laptopshaveanedge
fromaresiliencyperspective. Ifa laptopgetslost,stolen,or
blownup,wecanputafullyconfiguredreplacementoutwith
thenextconvoy.
Forstate-of-the-artlaptopsecurityproveninbankingapplica-
tions,however,IreturnedtoGoogle.Applyingthesamecrite-
riaofprovenbankdeploymentandchallengingprojectgeo-
graphy, Iwas led toPointsecMobileTechnology.Their solu-
tions,basedondisk levelencryption,hadbeendeployedfor
thousands of bank laptops in the U.K. and U.S. and proven
secureworldwide.
I picked up the phone and dialed the U.K. representative.
AgaintherewasapauseandasuckingofbreathwhenIsug-
gestedarapiddeploymenttoanetworkoflaptopsoperating
inIraq.Thenhesaid,‘Sure.Howsoondoyouwantdelivery?’
Anotherpieceofthepuzzlefellintoplace.
NowIhadthenetworksolution,Istillneededthefunctionality
which would make it worthwhile. This time I did not need
Google.Iknewwhotocall,VisaInternational.Thechoicewas
based on the belief that Visa could pop Iraqi Dinar on its
NationalNetSettlementSystemasanadditionalcurrencyand
process nationwide payments without major incremental
investmentoftimeandcapitalinprojectdevelopment.Using
an existing, proven, high capacity system was essential to
meeting the tight timeframe for enabling the currency
exchange.
VisaInternational’sNationalNetSettlementSystemoperates
domesticsettlementsofcardandelectronicpaymenttransac-
tions for many countries, including countries in the Middle
East and transformation economies in Eastern Europe. The
system provides secure payment processes, backed by the
VisaNetsecuritysafeguardsessentialtoauthorizingtransac-
tionsandcontainingtheriskoffraud.
ConnectingtoVisawouldalsohaverealadvantagesforinte-
gratingIraqwiththeglobaleconomy,allowingIraqisabroadto
send money to Iraq for investment and enabling Iraqi busi-
nesses to make efficient payments to foreign suppliers.
Importantly, it would embed a global data standard, the
16-digitcardnumber,aspartofpaymentoperationsinIraq.
IcalledStuartBrocklehurst,SeniorVP-PaymentsDevelopment
14 - The Journal of financial transformation
15
One of the benefits of staying current with emerging tech-
nologiesisthatitengendersabeliefinthepossible.Lastyear
Iwaschallengedwith theseemingly impossible, todesigna
bankingnetworkandpaymentsystemforpost-warIraqwhich
couldbefullyoperationalin10weeks,andfoundthatsatellite
data networks and web-based processes made it practical,
quick,secure,andmorefunctionalthananyoneexpected.
InJuly2003thetelecomswerestillknockedoutinmostof
central Iraq, theelectricitynationwidewaspatchy,with fre-
quent blackouts, and only a handful of bank branches had
reopened following widespread post-war looting of banks.
Meanwhilethesecuritysituationwasdeterioratingasinsur-
gents organized and gained access to weapons and explo-
sives.
Despitethesechallenges,theCoalitionProvisionalAuthority
wasdeterminedtoreplacetheoldcurrencyfeaturingSaddam
withanewcurrency.Thechangeoverwasscheduledtobegin
on 15 October 2003, and last for three months. The banks
nationwide would have to reopen to operate the currency
exchange.Inacountrywheremanypeoplekeepboxes,even
rooms,fullofcashintheirhomesinpreferencetothedubious
securityofbanks,theexchangewasgoingtobeamajorlogis-
ticalchallengeforeveryone.
Atan informal summerbarbeque,AndrewBailey (Executive
Director—BankingandChiefCashier)oftheBankofEngland,
tookmetothevegetablepatchatthebackofhisgardenand
askedmetothinkabouttheproblem.TosayIwas‘ledupthe
gardenpath’wouldbeunfair,ashewasfrankindescribingthe
chaos. The urgent need was a network which would enable
communicationsamong80branchesof theCentralBankof
Iraq, Rafidain Bank, and Rasheed Bank so that they could
reopen throughout Iraq, and a system to process electronic
paymentsamongthem.
Icouldhavelaughedawaytherequest,butIfeltIhadtomake
anefforttoaidacountryandapeopleattackedandinvaded
bymyown.
I bounced the problem off a friend specializing in wireless
telecomsandheimmediatelye-mailedbacksuggestingthatI
evaluate data services provided via satellite by Inmarsat.
Some intense Googling led me to the Regional Broadband
Global Area Network (R-BGAN). Portable R-BGAN modems,
whichareaboutthesamesizeandshapeaslaptopPCs,pro-
videbroadbandconnectivitytotheworldwidewebviadown-
linktoanearthstationatFucino,Italy.R-BGANcouldbeused
to provide real-time access to any web-enabled application
operatingremotelyonserversoutside Iraq.Crucially, Iraq is
centrallylocatedwithinthefootprintoftheInmarsatsatellite
supportingR-BGAN.Anaddedadvantageofthiswebconnec-
tivitywouldbetheeaseoftransferringservicestoasecure,
domesticInternetProtocolnetworkwhenitbecomesavailable
inIraq.
OnceIhadbroadband,IknewIcouldfindasolution!Ibegan
to sketch it out as laptop PCs connected by the R-BGAN
modemstoaback-endserverprovidingthecommunications
network,e-mail,andpaymentsapplications.Boththelaptops
andmodemscouldoperateoffbatterypowerduringthefre-
quentblackouts.
AtthispointIreinedinmyenthusiasmandgotpractical.Iset
myself some guidelines on technology and suppliers which
accordedwith thescaleof thechallenges inpost-war Iraq. I
decidedIwouldonlyconsidersuppliersofferingtechnologies
proveninbankdeploymentsinchallenginggeographies.Iraq
wasnoplacetotestnewtechnologiesorunseasonedproject
managers.Ialsodeterminedtokeepasmuchoftheback-end
servers and operational processes as possible outside Iraq,
although all processes should support the Arabic language
andbe transferable toamoresettleddomesticbankingsys-
tem.
GoingbacktoGoogle,IkeptsearchingonR-BGANuntilIfound
acasestudyondeploymenttomajorglobalbanksatbranches
inthelessdevelopedregionsofAfrica.Thedeploymenthad
beenmanagedbyNSSL,asatellitesolutionscompanybased
convenientlyinRedhill,England.WhenIfirstcalledNSSL,the
forCentralEurope,theMiddleEast,andAfrica.Iexplainedthe
challenge, thetimescale,andthesolutionarchitecture Ihad
developed so far, and asked if Visa would provide the pay-
mentsfunctionality.Stuartaskedafewquestionsandprom-
isedtogetbacktomewithinthehour.
A half-hour later he called to confirm the president’s view,
subjecttoapprovals,thatVisacoulddeliver.Overthefollow-
ingweekendallboarddirectorsapprovedVisaInternational’s
commitment to the Iraqibankingnetworkandpaymentsys-
tem. Given that we were in high holiday season, and many
directors were tracked down to beach cottages and boats,
theirunanimoussupportdemonstratedamarvelousenthusi-
asm.Visaevenofferedtocoverthesubstantialsetupcostsin
Iraq.
Connecting Visa to the Iraqi banking network was not the
technology ‘no-brainer’ Ihadhoped.Visausesaproprietary
networkanddatastandard.NSSLquicklywenttoworkwith
Visa’snetworksuppliertoovercomethis,enablingthetrans-
missionof transactiondata from Iraqover Internetprotocol
using a web-based connection and data transformation for
interoperability with the Visa network. It was an impressive
cooperation, displaying a ‘Blitz spirit’ toward engineering a
rapid,workablesolution.
My initial collaborative proposal was sent to the CPA in
Baghdadthefollowingweek.TheCPAhadnotreallyexpected
anyonetosolvetheproblem,sowasabitsurprisedtoreceive
afully-scopedsolution.Itconfrontedthemwithanotherprob-
lem.Theycouldnotawardacontractwithoutatenderpro-
cess,sotheIraqiBankingNetworkandPaymentSystemhad
tobeputoutforbid.Fourteencompaniesresponded,butno
other proposal provided high security and resiliency with
equivalentconfidenceindeliveryonthetimescalerequired.
Ourswasalsothelowestcost.
InthefirstweekofAugust2003,Stuartandtwoexecutives
fromNSSLflewintoBaghdadinanRAFHerculestransportto
negotiatethecontracts.Partofmewantedtobewiththemas
Ihadinvestedalotofmyselfinthesolution,buttherestofme
was happy to be sunning poolside at a villa in Greece, con-
nectedtotheteambyanR-BGANmodemloanedtomeforthe
purpose.TheyreturnedtoLondoneightlong,hotdayslater,
the day before the bomb at U.N. headquarters in Baghdad
which marked the most significant escalation in insurgent
violence.
Thesolutionwent liveontimeandtobudgeton15October,
2003,prettymuchasdesigned inmy initialproposal. Itwas
enhancedbyeightlevelsofsecurity:physical,logical,network,
data,access,andmore.Sincethenithasbeenusedtocoordi-
natethebankingoperationsofthecentralbank,Rafidain,and
Rasheed,bringingthebankingsystembackon-lineandmov-
ingittowardnormaloperations.
This summer, 2004, the system embraced the 26 private
banksoperatinginIraq,enablingthemtoofferVisatransac-
tions and make settlements through the central bank and
globally.
There is still a long, long way to go before Iraq becomes a
moderneconomywithamodernbankingsystem.Thesolution
wedesignedanddeployedwasaimedatmeetinganurgent
need indifficult times. Itprovidesastartingpointona long
pathofmodernizingtheIraqibankingsystem.
All solutions tocomplexproblems looksimple in retrospect.
ThesolutiondeployedinIraqmayappearobviousrevealedas
a completed whole, but there was twenty years of applied
expertiseonwhatapaymentsystemis,howitneedstooper-
ate,howbanksmustinteract,andhowtheprocessesmustbe
protected which went into specifying the solution last sum-
mer.Combiningpaymentsexpertisewithworkabletechnology
andsupplierswhocoulddeliverinIraqgaveoursolutioncred-
ibilitywiththebankersresponsibleforusingitindailyopera-
tions.
TheIraqibankingnetworkandpaymentsystemcanbecount-
edamongthefewsuccessesofthepastyearinIraq.Evenso,
16 - The Journal of financial transformation
17
Ilearnedsomevaluablelessonsthathavenothingtodowith
technologyorbanking.Firstlesson:nocontract,noclient.In
my zeal to get the job done, self-interest took a back seat.
NexttimeIwouldsortsomeagreementstoensureIgetpaid.
Second,corruptioncanfrustratethebesttechnology,andthe
Iraqi banking sector has been a magnet for returning exile
carpetbaggers.Evenwiththeoverwhelmingsupportofhighly
professional and enthusiastic native Iraqis who are deter-
minedtorebuildtheirnation,oursystemwasnearlyderailed
bythemalign influenceofafewinterlopers.Finally,there is
nothingmorepermanentthanatemporarysolution.Ournet-
work,originallytobereplacedbyaterrestrialsystemwithin6
months,isstilloperatingtoconnectthe81branchesinstalled
onit,andNSSLandVisaarecooperatingonaworldwidenet-
workleveragingthesuperiorresiliencyandsecurityfeatures
developedforIraq.
Itwasamad,exhilaratingsummerproject.Ihavenothingbut
respectforthepeopleintheCPA,CentralBankofIraq,NSSL,
andVisaInternationalwhomadearealityoftheideasIspun
frommydesktop.Astrongbankingsectorisessentialtoany
economicnormalizationinIraq,andweshouldallwishthem
successgoingforward.
unifying the European payments landscapePhilippe MenierChief Operating Officer, Visa Europe Ltd
example, Santander Central Hispano’s acquisition of Abbey
appearstobeheadingforasuccessfulconclusion.And,with
every passing week there is more speculation about yet
anothermega-merger.Clearly,partofthebusinessrationale
istoachievemorescaleandscope—optimizingthecostbase,
andeliminatingduplicateinfrastructures.
Asarelatedpoint, there is the fateof theshared,domestic
payment processing infrastructures. Everyone agrees that
Europecannotsupportaparallelinfrastructureineverysingle
country,sotheseincumbentsareactivelyhuntingforanew
remit.Intheworldofpaymentcardprocessing,forexample,
Interpay,Banksys,andSSBhavepooledtheirscalebycreating
the SiNSYS joint venture. Then of course there’s the SEPA
visionitself—allthosering-fencednationalsilostobesuper-
sededbyonebigdomesticmarket.
Thebankingindustrymayhavebeenreluctanttochange.But
the first round of regulation and the formation of the
European Payments Council (EPC) proved that this really is
not going to be a matter of choice. Coinciding with this we
havetheemergenceofanewlegalframeworkforpayments,
theCommission’sschemetoharmonizethelegislativecontext
for all payments, not just across the euro-zone, but all E.U.
countries. Covering transparency and liability, security and
fraudprevention,andrevocabilityandrefunds,itwillcreatea
levelplayingfieldacrossthecontinent.
Lookingmorecloselyatourownsector,cardpayments,there
is the European migration to EMV chip technology. This is
significantformanyreasonsbutinthiscontextitisthefirst
timethatEuropeisunitingaroundasinglecardstandard.The
casualobservermaythinkofthecardmarketashighlystan-
dardized.But,scratchbelowthesurfaceandyouseeamass
ofnationalidiosyncrasies.EMVrepresentsabigsteptowards
convergence.
So, yes, many different examples of convergence. I suppose
wehavebeenusingthisword‘convergence’foryearsnow—
toying with the possibilities, but mostly on a hypothetical
level.ItisabitlikethefamousoldquotefromStAugustine:
‘Lord,helpmetobegood—butnotjustyet.’
Nowweseem,finally,tohavereachedthemomentoftruthand
themindsetoftheindustrydoesappeartobeshifting.Evenso,
weare still at the startofavery long,difficultprocess, and
therearesomeverycomplex,emotiveissuestoresolve.
The future of processing studyAgainstthisbackground,VisaEuropecommissionedPayment
SystemsEuropetoundertakeamajorresearchstudyamong
Europeanbanksandprocessors—andsomereadersmayhave
participated in this. We asked for their opinions on today’s
cardprocessingmarket.Weaskedthemhowtheythoughtit
mayevolve.Thefindingsmakeforveryinterestingreading.
Intermsofthebigpicture,thereareprobablynottoomany
surprises. Yes, everyone agrees that SEPA is a worthy aim.
And yes, everyone agrees that it makes sense to move
towards a common payments architecture. In other words,
thereiscompleteconsensusonwhatandwhy.Whereitgets
moretricky iswhenwediscusswho,how,when,andwhere.
Theysaythedevilisinthedetail,andyoudonothavetogo
veryfarbeforeyoumeethimheadon!
But the important thing to acknowledge is this: no one is
happywiththestatusquo.Notthebanks,notthecommercial
processors, and not even the inter-bank processors. Even if
SEPAwerenotontheagenda,therewouldberealpressureto
change, and to move toward more openness, transparency,
standardization,andcompetition.Indeedthestudyshowsus
thatitisnotevenSEPAthatisthebiggestforceforchange.
NorisittheCommission’scompetitionintervention.Insteadit
is the needs and demands of the big pan-European banks
whichisregardedastheprimarychangedriver.
Withregardtothebanks,andlookingatissuerprocessingin
particular,arealdilemmaisrevealed;namely,what,when,and
howmuchtooutsource.Formanybanks,itseemstobecon-
stantlyontheagenda.Forexample,oneofthe20largebanks
18 - The Journal of financial transformation
19
Asmanyreaderswillbeaware,oneofthecentralobjectives
oftheEuropeanUnionhasbeentocreateasingleEuropean
market where there are no barriers to trade or commerce
across any of the member states. Although the European
Unionhasmadehugestridesinthisdirection,severalobsta-
clescontinuetostandinthewayofthevision,inparticular,
cross-borderretailpaymentshavebeenseenasundulyslow
andexpensive.
Anumberofcommentatorshaveenjoyedpointingthefinger
ofblameatEurope’sretailbanks,butthefactofthematteris
thatE.U.countries(justlikecountrieseverywhereelseinthe
world) have independently created a patchwork of parallel,
incompatiblepaymentnetworks.Giventhatthevastmajority
ofpaymentshasalwaysbeen,andcontinuestobe,domestic,
therehasneverbeenacompellingbusinesscaseforbringing
moreunity to thenational infrastructures.Thenetresult is
that,yes,cross-borderpaymentshavebeenslowandexpen-
sive.Andthisisgenerallyreflectedinthepriceandthequal-
ityofserviceexperiencedbybusinessesandconsumersalike.
Theonenotableexceptionisthecardpaymentsector.Since
its inception, the card systems have effectively ‘overlaid’ a
seriesofdomesticpaymentschemeswithinternationalfunc-
tionality and interoperability. In doing so, it has enabled
highly convenient, highly secure, generally instantaneous
cross-borderandmulti-currencypayments.And ithasdone
soatminimalcost.
Frustratedatthelackofprogressacrossothertypesofretail
payments, the European Commission is taking a tougher
stance.Ithasalreadyintroducedpayment-relatedlegislation
andhasinsistedthatEurope’sbankingcommunitymustnow
progresstowardsaSingleEuropeanPaymentsArea(SEPA),
where any regional payments can be made as easily and
cheaplyasinthelocalmarket.Giventhesuccessofthepay-
mentscardindustryinmitigating,ifnoteliminating,anum-
beroftheaforementionedissues,itmightbeworthassessing
whetherthecardpaymentsector,eitherdirectlyorbyexam-
ple,canplayaroleinhelpingtheindustryachieveitsobjec-
tives.
our perspectiveIt should be noted from the onset that we are not a single
entity,rathertheVisaorganization,likeourpeers,isaninter-
nationalassociationofbanks,unitingmorethan5,000banks
in Europe, and 21,000 worldwide. In Europe, these member
bankshaveissued230millionVisacardswhich,during2003,
wereusedtoconduct824billionworthoftransactions,rep-
resentingclosetotenpercentofpersonalconsumerexpendi-
tureacrossEurope.Memberbanksalsosignupmerchantsto
acceptVisa,orother cards issuedbyourpeers, inorder to
benefitfromfast,efficient,guaranteedcashlesspayments.We
actasthegluewhichbindseverythingtogether.Forexample,
wemanagethebrand,providetheprocessinginfrastructure,
andworkwithbanksandregulatorstoagreeandenforcethe
operatingrulesandregulations,definingtheprecisewaythat
paymentsmustwork,andtheresponsibilitiesofeachpartici-
pantineverytransaction.
Europeanbankswerethefirstnon-Americanparticipants in
Visa.Theywerealsothefirsttoregardit,notasacreditcard
system,butagenericpaymentmechanism.Accordingly,they
werethefirsttoissueVisadebitcards,andthevastmajority
ofourEuropeancardscontinuetobedebit.Sincethesedebit
cardsarethedominantpaymentmeansandthepivotalpoint
ofthebankingrelationship,theytendtohaverealstrategic
significanceforanyretailbank.Accordingly,effectivegover-
nanceandcontrolofthepaymentsystemisatoppriorityfor
European banks, and a highly pertinent issue for European
regulators.Itis,therefore,worthadmittingtoavestedinter-
est—byacknowledgingthatVisahasaverybigstakeinthe
waytheEuropeanpaymentsindustryevolves.And,onbehalf
ofourmemberbanks,weareworkinghardtoinfluencethat
evolution.
convergence across banking and paymentsBefore looking at the specifics of the European retail pay-
ments sector, it is perhaps worth considering the broader
context, by which I mean the multiple convergence trends
acrossthebankingandpaymentssectors.Firstly,themergers
and acquisitions continue apace. At the time of writing, for
cultsituation.Theysaythatthebankshaveanew-foundpre-
occupationwithcostsandefficiencies,oftenattheexpenseof
revenue generation and profitability. Consequently, all they
wantfromtheprocessorsisvanilla-stylecommodityservices.
Clearly,itisnotatalleasyforanyprocessortoexcelinthese
circumstances, particularly when you have to upgrade your
systems,themarketishighlyoversupplied,andtherearebar-
rierstointernationalgrowth.
Ultimately,oneisdrawntotheconclusionthat,with80-plus
commercialandinter-bankprocessorssomethinghastogive.
The banks said, yes, the market has to shrink substantially,
andtheconsensuswasthattheremayberoomfor20to30
players.Theprocessorsagreed,theytoosaidtherewasroom
for20to30playersandsuggestedthatwouldbethesizeof
themarketjustsevenyearsfromnow.
other cross-border retail paymentsItshouldbestressedthatwhatwehavebeendiscussingsofar
is the payment card market and payment card processing.
This is a payments market which is commonly perceived as
themostuniform,theonethatisclosesttotheSEPAideals,
andhasthefewestadjustmentstomake.Sowhataboutthe
prospectsforothertypesofpayment?
Visa has also spent some time analyzing the ACH market.
Specifically, we conducted some very detailed, structured
discussions with our members, and also with the national
ACHs.Incidentally,ouraimwasnottodefinehowVisacould
replaceexistinginfrastructuresandmarketplayers,rather,we
wantedtoexaminewhetherourprocessingcapabilitiescould
enhance thecapabilitiesof incumbentplayers—perhapsby
providing complementary, value-added processing services,
which could result in reduced costs and increased revenues
forbanks.
Again, the findings are extremely interesting. Firstly, it was
thoughtinevitablethatpan-Europeanclearinginfrastructures
will emerge to replace the existing, local ACHs. Moreover, it
wasrecognizedthatthescaleandthefunctionalityofVisaNet
couldaddvaluetobanksandtheprocessing infrastructures
theyareusingtoday.Consequentlymostbankshadaccepted
that,yes,theywouldhavetoinvest—atsomestage.Butwith
alackofclarityregardingthefuturelandscape,itwasgener-
ally thought that now was not the time to make such an
investment.Itwasalsothoughtthat,yes,inanidealworldit
wouldbebesttohaveachoiceofcompetitivePEACHes.But,
ofcourse,thisisnotanidealworld,andtherewasnoappetite
toco-investinanalternativePEACHinfrastructure.
Finally,weaskedtheselargebanksabouttheenvironmentten
yearsfromnow.Theyallagreedontwopoints.Firstly,theyall
agreed that, ten years from now, there would not be more
than4to5wholesalepaymentclearers.And,secondly,all12
bankswespoketoagreedthattheywouldbeoneofthefour
orfivesurvivors!
where to from here?Evenifwearetoconfineourconsiderationstothepayment
cardsector,itisclearthatEurope’sbankshavesomedifficult
choices to make. Let us look at some of the criteria that I
believewillbeimportantinthedecision-makingprocess.
grasping the EmV opportunityAsIhavediscussed,there isdefiniteconsistency intheway
thattheEuropeancreditcardmarketfunctions,andthisalso
extendstochargecardsandsometypesofdebitcard.This,
however,isnotthecaseforalargechunkofthedebitmarket,
particularly in central Europe. Indeed, there are 15 different
domestic card implementations, each of which has its own
particular rules, regulations, and processing infrastructures.
Thecasualobservercouldsuggestthatthecreditcardmodel
shouldsimplybeexportedacrossEurope.Given thehistory,
andthefactthatthedebitcardissoverypivotalinthebank-
ingrelationship,theindustryinsiderwouldlabelsuchasug-
gestionasnaïve.
However, with the implementation of EMV chip technology
right across the region, there is an historic opportunity to
20 - The Journal of financial transformation
wespoketosaidtheywouldoutsourcealloftheirissuerpro-
cessing immediately, ifonlya suitableprocessorwereavail-
able.Anotheronehadjustchangeditsprocessor.Anothertwo
were in the process of changing, and yet another had just
moveditsprocessingbackin-house.
Sowhatisgoingonhere?Thesebankssaytheyarefrustrated
by the lack of choice and flexibility, they do not like to be
dominated by inter-bank processors, and they are not
impressedwithwhatisonofferfromthethird-partyproces-
sorseither.Yes,theyhavegotanelementofchoicewhenit
comestotheircreditcardprocessing,but,forbanksinmain-
landEurope,thepriorityisinvariablydebit.
Buthowdotheybreakthedeadlock?Again,itisagreedthat
thelargerbankswillbetheonestodecide.Onbalancethese
bigbankssaythat,yes,theywouldliketoseecloseddomestic
markets opened up to competition. They are in a situation
where they are supporting a different inter-bank scheme in
everycountrywhere theyoperate,andeachscheme ispre-
sentingthemwithabigbilltoreplaceanagingdeliveryplat-
form.
Buttherearenotanyeasyexitstrategies.Oneoptioncouldbe
torenewtheirsupportfortheseincumbents,helpingthemto
pursuepan-Europeanstrategies,towincross-bordervolumes
andtherebydrivedowncost.Alternatively,theycouldorches-
tratethesaleoftheseinter-bankprocessors,dismantlinglocal
defensive barriers, and effectively opening the door to the
U.S.-stylethird-partyprocessors.Bothstrategieshavedefinite
drawbacks,sothemorelikelyscenarioisgradual,market-by-
marketliberalization,aswehavebeguntoseeinScandinavia.
Barrierscouldgraduallybe lifted,andstep-by-stepcommer-
cialprocessorscouldbe invitedandencouragedtocompete
withtheinter-bankconsortia.Inthisway,competitionwould
begintochangethemarketdynamicsandimprovethequality
andrangeofservices.
Formany, this isamorepalatableoption.But,evenso, it is
slow,unpredictable,andstillnotacompletesolution.Whatthe
bigpan-Europeanbanksreallyneedismulti-countrysolutions
forissuing,acquiring,andATMs.Today,fewifanyprocessors
couldofferacredibleservice.
So, how about the processors themselves? These organiza-
tionsfallintotwobroadcamps,thecommercialprocessors,or
TPPs, many of which are owned and/or operated by large
Americanmultinationals,andthemutuallyownedinter-bank
processors. It is interesting to note that, although the U.S.-
stylethird-partyprocessorsareadmiredfortheircommercial
focus they do not seem to have adjusted to the realities of
Europe.Bankssaytheyareunhappywiththeirstyleandcom-
plainthatthesolutionstheyareofferedtendtobebasedon
theU.S.orAnglo-Saxonmodel.Theyarefrustratedbyalack
of understanding of the specific requirements of individual
banks in different European countries. It is even suggested
that by simply getting out on the road more often senior
executives could do much to address the skepticism. Also,
thankstotheirfileconversionexpertise,theyhaveaparticu-
lar opportunity in cross-border processing. And, as I said
before, the bigger banks are actively looking for such solu-
tions.
Ishouldstressthatthisisnotanexerciseinanti-Americanism.
Manyofourhomegrownprocessorswereseverelychastised.
Banks tend to believe they get higher quality services from
theirin-houseoperations,andthisreflectsbadlyontheentire
sector.
Movingtotheinter-bankprocessors,thesurveysuggeststhat
theymaybefacinganuncertainfuture.Therewassomecriti-
cismover thequalityofserviceand thecostsof redevelop-
ment. However, no one should underestimate the level of
supporttheyretain.Severalbanksbelievethereisdefinitelya
futureforcooperativeplatformdevelopmentandsharedser-
vices.Theconclusionisclear,solongasitadaptstothereali-
tiesofalarger,moreuniformEuropeanmarket,theinter-bank
cooperationmodel isaliveandwell. It shouldalsobenoted
thatmanyoftheprocessors,irrespectiveofwhethertheyare
thirdpartiesorinter-bankconsortia,faceanimpossiblydiffi-
21
unite, and possibly even converge, around a common plat-
form.Whatwearetalkingabouthereisthecreationofanew
AlwaysChip—AlwaysPINdebitproductforEurope.Inafew
years, Europe will be a mature chip market — indeed, more
than90%ofterminalsandcardswillbeEMV.Inotherwords,
the environment will accommodate fully secure cards, debit
cards inparticular—forwhichconsumers’securityexpecta-
tionsarenotfullymettoday,especiallywhentheytravelout-
side of Europe. To the extent that there is a consensus, it
appears to be that Europe’s banks should aim for a fully
securedebit solution,whichat thepoint-of-salewillbechip
andPINonly.
With no exception items, no skimming of the magstripe, no
fraud,andtheopportunitytooperateoff-lineinselectedenvi-
ronments,suchaproductwouldresultinlowerunitcostsfor
all participants, which would in turn lead to increased mer-
chant and consumer confidence. Our own proposal is for a
product which is fully owned and controlled by Europe’s
banks,andwhichoperatesunderitsownacceptancemark.It
wouldbeabletocoexistwithdomesticdebitschemes,aslong
asthebankswhoowntheseschemesfinditappropriate.Of
course, it would also be an ideal point-of-convergence for
theseschemes.Althoughtherearedifferingviewsaboutthe
timingforsuchconvergence,withinandamongcountries,no
one isarguingwith the fact that itwillandmusthappenat
somepoint.AtVisaEurope,weare,therefore,eagertowork
witheachofourmemberstoseehowsuchaproductcould
help them evolve towards a more secure, more convenient,
andmorecost-efficientEuropeandebitscheme,toppedupby
aEuropean-onlygovernancestructure.
maintaining European ownership and controlWhatsomeobserversfailtoappreciateisthatownershipand
controlofthecardpaymentsystemisahighlyemotivesub-
ject for European banks. Thinking back to chip cards, for
example, theEMVspecification itselfwashammeredout in
Europe,andEuropeistheclearworldleaderinimplementing
it.ThenatureofthecardsissuedhereinEuropeisverydif-
ferentfromelsewhereintheworld,andtheirusagepatterns
arealsoquiteunique.Additionally,nootherbanks face the
challenge of migrating from separate, multi-country infra-
structures to a more unified regional infrastructure. The
recentconstitutionalchangesatVisaEuropeareareflection
of this situation. Traditionally, we operated as a branch of
VisaInternational.But,asofJuly2004,wecreatedasepa-
rately incorporated company called Visa Europe. In effect,
thismeansthatEurope’sbanksarethejoint-ownersofadis-
tinctEuropeanpaymentsbusiness,andtoreflecttheirpropri-
etary interest each one holds a nominal, non-transferable
shareinthecompany.Yet,tomaintainourinternationalism,
VisaEuropeexistsasagroupmember—andco-owner—of
VisaInternational.
Inbusinessterms,incorporationmeansthatwecanaccelerate
ourEuropeandevelopmentwork.Italsomeanswecandevel-
op more technology services and have the freedom and
opportunity toenter intocommercialpartnershipsand joint
ventures. Incorporation also has profound symbolic signifi-
cance.ItdemonstratesthatEurope’sbanksaretheexclusive
owner-operatorsoftheirownregionalpaymentsystem.With
an unambiguous European focus, and pan-European repre-
sentation, we can express their views and represent their
interestsmoreforcefullywithEuropeanassociations,regula-
tory bodies, and forums. In particular, we want regulators,
industry bodies, and working groups to regard us as a wel-
comeandauthoritativepartner.
This issueofownershipandcontrolalsoextendstothepro-
cessinginfrastructurewhichtiestogetherthevariouspartici-
pants. Our various surveys suggest that Europe’s banks are
unwillingtocedecontroltothird-partytechnologycompanies.
PerhapstheyhaveglancedacrosstheAtlanticandseenthe
weightofinfluencewhichsuchcompanieshaveontheterms
andthecostsoftheentirepaymentmarket.
In summary, I believe that Europe’s banks have a deep and
enduring appreciation of the strategic significance of elec-
tronicpayments.Icontend,therefore,thatanycompaniesor
organizationswhichseek to representor serve thesebanks
22 - The Journal of financial transformation
23
credit card security on the net: where is it today?Sankarson BanerjeeSenior Architect, Mphasis
Internetcommerceisheretostay.Ithasbecomeacommon
methodofpurchaseforawiderangeofproducts,andcontin-
uestogrowatagoodclip.Thedominantpaymentvehicleon
theInternetis,andhasalwaysbeen,thecreditcard.Indeed,
thetwoareinseparable.E-commercedoesnotdowellwhere
creditcardusage isnotprevalent,andthe Internethascer-
tainlygivenaboosttocardspending.
WhenInternetcommercefirstcamealong,creditcardissuers
were woefully under-equipped to handle the security issues
that emerged from this new way of doing business. Credit
cardsweremeanttobephysicallypresentedatthepointof
thesale,sothatthemerchantcouldvalidatethetransaction
andobtainasignaturethatrepresentedalegallybindingcon-
tract to pay between cardholder and merchant, with the
creditcard intermediariesactingasfacilitators.TheInternet
introducedawholenewparadigm,wheresellersandbuyers
did not come face-to-face, could easily hide their identities,
andrequirednosignature.Thisledtohighratesoffraudthat
oftenleftmerchantsreelingandcustomersunhappy.
Thecreditcardindustryhasrespondedwithmanymeasures
aimedatloweringtherateoffraudtoacceptablelevels.Some
measureshave,overtheyears,becomequitewidespread.This
articlestudiesfiveschemesthatwerelaunchedbythecredit
card industry in the last few years, and how well they have
servedtheirpurpose.
card Verification Value (cVV2)One of the earliest measures dates back nearly a decade.
Also called the Card Validation Code (CVC2) or Card
IdentificationNumber(CID),itisa3-digitnumber(4-digitfor
Amex)printedonthecreditcardthatisnotinraisedlettering
andnotpresentinthemagneticstrip.Itdoesnotshowupon
creditcardreceiptseither.ThesenumbersarepresentinVisa,
MasterCard, Discover, Amex, and Diners cards. MasterCard
has had it on every card issued 1997. The way it works is
simple; websites ask the user for the CVV2 along with the
cardnumber.Itdoesnotverifytheidentityofthecardholder;
itjusttriestoensurethatthepersonhasthecardphysically
availabletohimorheratthepointofpurchase.
Thoughthetechnologyhasbeenavailableforthebetterpart
ofadecadenow,implementationeventodayispatchy.Credit
card companies will not refuse transactions where the CVV
doesnotmatch;onlyaflagissentbackandthemerchantis
allowed to decide if CVV match should be enforced. More
importantly,exceptinthecaseofAmericanExpress,collecting
andmatchingaCVVnumberdoesnotprovideamerchantwith
any additional protection against charge-backs. A purchase
canbedisputedandchargedbacktothemerchantevenifthe
CVVnumberwascorrect.Therateofcharge-backislowerthan
theratesatwhichCVVmatchesfail,soevenlegitimatecard-
holdersareenteringtheirCVVwrongsomeofthetime.
CVVdoesnotreallypreventtrustedpartyfraud.Thewaiteror
grocerystoreclerkentrustedwithswipingthecardcancopy
theCVV justaseasilyas thecardnumber. Iteliminates the
situationswhereadiscardedcharge-sliporstatementcanbe
usedtolocatethecreditcardnumber,althoughgettingcredit
carddetailsfromtheformerisalreadybecomingmorediffi-
cult as most now mask part or all of the number. It does,
however,seemtolowerthepercentageoffraud;theeffectis
possiblythatofapsychologicaldeterrent.
3d security3D, or Three Domain security, is an Authenticated Payment
Solution.Thismeansthatthepersonmakingthepaymentis
authenticated,astheholderofthecreditcard,inadditionto
thepayment itselfbeingauthorized.Visa’ssolution iscalled
‘VerifiedbyVisa’.ThewayitworksisthatVisaasksthecus-
tomerataparticipatingmerchant’ssitetoconfirmboththe
creditcardnumberandenterapre-decidedPINorpassword.
IfthePINisnotenteredcorrectly,thetransactionisrefused.
ItisveryunlikelythatacreditcardthiefwillknowthePIN,so
the transaction should be safer. Further, the PIN cannot be
accessed by someone in temporary possession of the card.
MasterCardhasasimilarprogram,calledSecureCode.
Thesuccessofthesystemisdependentontwofactors,that
thecreditcardcustomerswillenrollthemselvesintheVerified
forVisaprogramandcreateaPIN for themselves,and that
the merchants will participate in the program. Customer
acceptancedoesnotseemtohavebeenpoor;Visaestimates
thatnearly40%ofitscustomersintheU.S.arenowenrolled.
Merchants,however,havebeenfarlessenthusiastic.Barelya
handful of Internet sites support the mechanism, and most
majorretailershavenotshownenthusiasm.
The question here is the kind of protection this program
affords, and who it protects. Assuming that the cardholder
takes reasonable care with the PIN, this affords protection
against misuse on the sites that support it. However, two
pointsmustbemade.Firstly,mostconsumersarealreadywell
protectedfromunauthorizedchargesontheircreditcardsby
the card issuer. Except for the inconvenience of having to
dispute a charge, the cardholder is usually not liable for a
fraudulent transaction. Secondly, unless the card covers a
largemajorityofmerchantseverywhereontheInternet,there
isverylittletodeteracardthief.Thereasonwhymerchants
havenotshownenthusiasmisthattheystandtogainlittleby
thisprogram.Adoptingtheprogramdoesnotgetthemlower
interchangefeesreflectingtheloweredriskofdoingbusiness.
It does not even protect them against the cost of bearing
charge-backs.Customerscanstilldisputechargesand,justas
inthecaseofCVV2,noextraconsideration isgiventomer-
chants.Mostmerchants,therefore,arereluctanttomakethe
change,whichmeansimplementationcostaswellascustom-
erissues(1-clickordering,forinstance,willnolongerwork).
Address Verification systems (AVs)The theory behind address verification is that the billing
addressofacreditcardismoredifficultforathieftogather.
Awaiteratarestaurantcaneasilynotedownthecardnumber,
buthasnowayofobtainingthebillingaddress.Furthermore,
merchantscaninsistthathighvalueproductsbeshippedonly
tothebillingaddress,makingitlesslikelythatsomeoneother
thanthecardholdercanbenefit fromthepurchase.Address
Verification is todayavailable forallcardholders in theU.S.,
andinsomeothercountriesliketheU.K.
Addressverificationrequiressubstantialinvestmentbycredit
cardissuers.Issuersaretheonlypersonswithaccesstothe
customer’s billing address and their ability to publish this
informationreal-timetopaymentprocessorsiscriticaltothe
AVS method. Countries outside the U.S. have been slow to
adapt to AVS, so this method is usually not available for
Internationalcustomers.BillingaddressevenwithintheU.S.is
not guaranteed reliable. Some users do not update their
addresseswiththecreditcardcompanywhentheymove,rely-
inginsteadonforwardingservicesofthepostoffice.Byand
large,however,billingaddressestendtobecurrentandusing
themasverificationcanbequiteeffective.
Therearesomeproblems,however.Forexample,creditcard
thievesdonotfinditsodifficulttolocatethebillingaddress
of a person; these are routinely stored with the merchant
along with the credit card number. It can also be obtained
from a person’s discarded statements. In this respect, it is
muchweakerthan3DSecure.Someoftheseproblemscanbe
addressed by insisting that goods (especially high value
goods)beshippedonlytothebillingaddress,thuspreventing
thethieffrombenefitingeasilyfromthepurchases.However,
thiscreatesmore issues. Itdoesnotworkforsoftproducts,
suchassoftwarelicensesorporn,andmakesitmoredifficult
forpeopletosendgifts,whichformalargepercentageofthe
commerce. Additionally, many people send their credit card
statementstotheirownortheiraccountant’soffice.Because
oftheseissues,AVSisusedmoreasacheckthanamecha-
nismtoguaranteeatransaction.
surrogate numbersOne clever way to avoid exposing credit card numbers to a
merchantistousedisposablecreditcardnumbersgenerated
foraspecifictransactionandvalidonlyforafixeddurationor
withaparticularmerchant.
Two companies lead in this technology, which has been
adoptedbysomeoftheworld’slargestcardissuers.American
ExpresscallsitPrivatePaymentsandMBNAcallsitShopSafe.
Theprocessissimple.Whenmakingapurchase,thecustomer
24 - The Journal of financial transformation
25
uses a small application to generate a one-use credit card
numberwithafixedvalueandashortvalidityperiod(usually
twomonths).Thiscardnumberisvalidonlyforonetransac-
tion,or forrepeatedtransactionswithinthevalidityperiod.
The credit card company maps these temporary numbers
backtothecardholder’soriginalcard.
Thetechnologyisveryeffectivewhenusedagainstunknown
merchants,especiallyonauctionsitesorforpurchasingone-
offservicesfromsmallsites.Itisprettymuchimpossiblefor
themerchanttodefraudonthetransactionoutsidethescope
definedbythecustomer.
Issues still remain. This approach negates the huge conve-
nienceof 1-click shopping, requiring thecustomer to fill the
card details each time. Furthermore, for services which are
bookedwithacardbutrequiretheproductionofthatcardat
thetimeoftakingdelivery,suchaswithmovieticketsorair
tickets,thisapproachcausessignificantheadaches.
Anotherissueisthatifthismethodisadoptedforwidespread
use,therewillsoonbeashortageofnumbers.Ofthe16digits
onacreditcard,only10aretrulyvariableforasingleissuer,
leadingtoapproximately10billionpossiblecards.Thatisnot
aproblemwhenphysicalcardsarebeingissued,butitiscer-
tainly not a large limit if each transaction uses a different
temporarycardnumber.
chip cards and smart cardsCredit cards with embedded chips were supposed to be the
ultimatesecuritymechanism.Suchcardsareverycommonin
Europe,wherealargenumberofMasterCardbrandedcredit
cards have them. In the U.S. American Express is the only
major issuer to offer them, on one of their cards (The Blue
card).
Ifallthepiecesofthecreditcardtransactionweresmart-card
enabled, the transactioncould indeedbemadeverysecure.
This,however,involvestheuseofasmartcardreaderanda
computer with the appropriate software; both prove to be
troublesome.Whilecardreaderhardwareisoftendistributed
free,fewusersgothroughthetroubleofhookingthemupand
installingthem.Thereadersareinconvenientforlaptopusers,
whomaynotevenhaveaslottoplugtheminto.Furthermore,
most households in America have multiple computers, and
usuallyonlyonereader issuppliedfor freewitheverycard.
Becauseoftheseandotherissues,usageofthesmartcapa-
bilitiesofthesecreditcardsisverylow.Mostpeoplejustuse
themasregularcreditcards.Merchantstoodonotinvestin
fullysmart-cardenabledpurchasingmechanisms.
conclusionNone of the new measures studied really provide the silver
bullet,theonewaytoensureacompletelysafetransactionon
the Internet for both merchants and consumers. Most offer
somelevelofincreasedprotection,butdonotreallyaddress
theissueofexcessivecharge-backs,anissueofprimarycon-
cernwithmerchantsandissuers.Thisisdirectlyreflectedin
the reluctance by VISA and MasterCard to lower the inter-
changefeeschargedforInternettransactionsevenifoneof
thespecifiedmethodsisadopted.
Credit card usage on the Internet is clearly on the way up.
Fraud rates, though higher than with other channels, have
heldsteadyforsometime.Muchofthis isthepsychological
assurance that these measures, often well publicized, have
contributed to better security. It increases consumer confi-
denceinthesystemandpromotestheperceptionthatfraud
isdifficult.
Amoreimportantreasonisprobablytheincreasedabilityof
merchantstotrackandprosecutethebigoffenders,andtheir
increasedabilitytodetectandpredictfraudulentbehaviorso
thattheycancarryoutmoredetailedchecks(possiblyoffline)
onindividualtransactionsthatseemsuspicious.Thatisprob-
ablythewayitisgoingtocontinue—betterpolicing,smarter
detectionofpossiblefraud,andconfidencebuildingviaindus-
try-widemeasures.
Broadening the value proposition around payments outsourcingThomas HalpinVice President, JPMorgan Treasury Services
advice-to-receive MT 210 matching tools that improve trea-
sury and receivables management, as well as Web-based
toolsthatimprovecustomerserviceandinformationreport-
ing(i.e.fasterinquiryresponseandtheabilitytoproactively
steminquiries).Suchcapabilitieshelpthebuyersofanout-
sourcingsolutiontodifferentiatetheirpaymentserviceswith
theirowncustomerbase. Institutionsconsideringmigrating
toanoutsourcingsolutionshouldlearnaboutthevalue-add-
edcapabilitiesthatpotentialoutsourcingprovidersincludein
theirsolutions.
Such features help broaden an outsourcing solution’s value
propositiontoonethatpotentiallyimprovesclientsatisfaction
and creates new revenue streams that support a model of
businessgrowth.Atthesametime,abuyerofpaymentsout-
sourcingretainsitsdirectclearingmembershipforcontinued
visibilityinthemarket.
core competency or competitive advantage?Distinguishing between core competency and competitive
advantageiscentraltothedecisionofwhethertopurchasean
outsourcing solution. Potential buyers should ask, ‘How can
weobtaincompetitiveadvantageinservicesthatourclients
expectustodeliver?’Corecompetencyissomethinganinsti-
tution does well, but competitive advantage is what a firm
mustestablishtodifferentiateitselfinthemarketandcreate
long-termsustainablewealth.
The new reality for the financial services industry includes
industryconsolidation,newregulatoryrequirements,increas-
ing business-resiliency measures, evolving client needs, and
changing technology. Today financial institutions must hon-
estlyassesstheirbusinessstrategytoensuretheyaredirect-
ingresourcesinamanneroptimalforgeneratingsustainable
profitability.
Whenconsideringoutsourcingpayments, institutionsshould
assess the impact of maintaining their current model and
evaluatethefuturedirectionofthemarketandthechanges
requiredtostaycompetitive.Theyshoulddistinguishbetween
corecapabilityandcompetitiveadvantageandconsider the
outsourcingoptionfromabroadenedperspective.
26 - The Journal of financial transformation
27
Historically,paymentsoutsourcinghasbeenviewedasacost-
savings measure. Today, financial institutions are searching
for alternatives to maintaining their own infrastructures for
deliveringtransactionservices.Institutionsarerealizingthat
apaymentsoutsourcingsolutionhasabroadervalueproposi-
tionthancostsavingsalone.Therightsolutioncanbeastra-
tegic decision that drives revenue growth, deepens client
relationships,andsupportssustainedprofitability.
Key to this broadened value proposition is finding the right
outsourcing provider, one with the scale to drive efficiency
alongsiderobustproductcapabilitiesandbestpracticesthat
improve quality while providing superior controls. Further-
more, a provider should demonstrate a long-term commit-
ment to maintaining a best-of-breed capability, which helps
the solution’s buyers gain a competitive edge in delivering
paymentsservicestotheirowncustomerbase.
Tipping the scale towards profitable growthInstitutions without the scale of business to compete effi-
cientlymust findviablealternatives to theirownpayments
infrastructure. Many are looking for ways to leverage the
scale of other providers in order to stay in the payments
space.Anoutsourcingmodelisemergingasastrategicsolu-
tionthatenables institutionstocontinueservingtheirmar-
ketswithpaymentsservices.Andtherightoutsourcingpro-
vidercanhelpitsclientsincreasetheirexistingcapabilitiesso
astodifferentiatetheirservicesforcompetitiveadvantage.
choosing an outsourcing modelA number of today’s outsourcing vendors, including banks,
serveasapplicationserviceproviders (ASP).Amoreselect
fewalsoofferabusinessprocessservicesmodel(BSP).With
theASPmodel,thevendorhostsafundstransfertechnology
solutiononbehalfoftheinstitutionalclient,whiletheclient
continues to provide the resources for pre-processing and
post-transactionserviceactivities.With theBSPmodel, the
vendorprovides transactionprocessingandserviceactivity
— including investigations, repairs, and other day-to-day
operationsthatsupporttheclient’spaymentclearingactivity
—inadditiontohostingthetechnologyplatform.
ThekeytoaBSPapproachisthatthesolutionneverlimitsthe
client’sabilitytocontrolitspaymentflows.Rather,itgivesthe
client options and choices for how to manage their funds
transferactivity.Forexample, theclient canelect tohandle
the payment release, repair, and settlement, or choose to
engageinbalancemonitoringtoensurethattheircustomers
haveenoughfundstoauthorizepaymentrelease.Thebuyer
oftheoutsourcingservicemaintainscontroloverthebusiness
processesanddecidesitslevelofinvolvementinthecontinu-
umofprocesses.
Potential buyers of outsourcing services should consider
whether a vendor offers both ASP and BSP models or pro-
vides a technology platform only (ASP) and outsources the
BSPcomponent,asavendorthatactsasanapplicationser-
viceprovider,butalsooffersbusinessprocessservices,may
beoutsourcingthatcomponenttoyetanotherprovider.
maintaining excellence for the long-term Buyersofpaymentsoutsourcingshouldbesurethatpotential
providers have a vested long-term interest in maintaining a
leadingcapabilitythatincorporatesbestpractice.Thislevelof
commitment can be a differentiator when distinguishing
among outsourcing providers. Demonstrated market leader-
shipoftenreflectsaclear long-termcommitment.Whenthe
underlyingpaymentsbusiness ismission-criticaltoaprovid-
er’soverallfranchise,itmeansthattheproviderhasavested
interestinmaintainingabest-practiceenvironmentandstay-
ingattheforefrontofthepaymentindustry’sfuturedirection.
Consequently,best-in-classprovidersshouldenableclientsto
benefitfromstraight-through-processingratesofcloseto97
percent on their pre-processing activities, which lowers the
numberofprocessrepairs.Ofcourse,alowererrorrateand
improvedpaymentprocessingefficiencytranslatesintomore
timelypaymentsand improved liquiditymanagement.Best-
in-class providers should be expected to have invested in
value-addedfeatureslikee-mailnotificationofpaymentsand
Bringing payments togetherMichel AkkermansChairman and CEO, Clear2Pay
theever-changingdemandsofthecustomer.Paymentsplat-
formsthatareinexistencetodaywerejustnotbuilttocater
forthismodel.
Totacklethe issuesof loweringcost, improvingservice,and
supportingnewproducts,banksneedtoembarkonatechnol-
ogy refresh. This technology refresh cannot simply be a
replacement.Theneedforoptimizationofbusinessprocesses
isasbig, ifnotbigger,thanthedeploymentofsystemsthat
make wide use of the Internet and associated technologies.
Theansweriscertainlynottotakethe‘big-bang’approach.It
isnotpracticaltobelievethatthereisamagicaloff-the-shelf
solution to this problem. Though payment systems seem to
caterforthesameneedstheworldover,thedifferencesfrom
onebanktothenextaresignificant.
Whenconsideringthisproblem,itiseasytolosesightofone
ofthemostfundamentalissues,thebusinessprocess.Whilst
allthesilosthathavebeendevelopedaretocaterfordifferent
typesofpayments,whenbrokendowntothelowestcommon
denominator, a payment, irrespective of type, involves the
debitingofoneaccountwithanamountandthecreditingof
another account with that same amount. We need to bring
paymentstogetherbygoingbacktothebasics.
There is a wayAbankshouldtakeacorporateviewofpaymentsasanenter-
prise-wideissue.Theyshouldlookforasolutionthatabstracts
thepaymentprocessfromthechannelsandthatoptimizesthe
businessprocessesirrespectiveofpaymenttype,recognizing
thatwhetherapaymentisalow-valuebatchACHtransaction
orahigh-valuecross-borderpayment,thecoreprocessesare
mostly similar. Common processes are, for example, balance
and limit checking, account number validation, deadline and
cut-offverification,branchidentifierorsortcode.Thesepro-
cessesareimplementedinthemainprocessflowsirrespective
ofpaymenttype.Itbecomesimportanttounderstandthedif-
ferences,isolatethosedifferences,andprocessthemaccord-
inglyoutsidethemainprocessflowsinbusinessprocessesthat
handlethoseuniqueexceptions.Thisistheroutetoradically
reduceprocessduplication,reducinginturntheneedfordupli-
cateinfrastructureandultimatelyleadingtolowercost.
Thesecondpartofthereflectioncentersonhowtoestablish
the roll-out of a payment hub while respecting legacy pay-
mentsystemsandarestilloperatingtothefullsatisfactionof
allconcerned.Mostofthesearetypicallyconnectionstolocal
domestic and international payment networks. A phased
approachmovingawayfromthesiloedpaymentprocessesis
an appropriate route, as it significantly reduces the risk of
failure in building the next generation payment processing
platform. Phasing involves establishing an inventory of the
systemsinplaceandmappingthemagainstthenewservices
thatneedtobeprovided,whilemaintainingtheendgoalofa
component-basedpaymentinfrastructure.
Thestepsofestablishingthephasingfortheroll-outare:Map
the existing bank payment systems against the optimized
component-basedpaymentinfrastructure,prioritizebyidenti-
fyingurgentneedsandselectingkeycomponentsagainstthe
optimizedinfrastructure,andimplementthenewservicesand
initiate gradual migration to the new infrastructure of the
legacysystems.
Over time the payment type independence, the component
re-use, and the volume growth will be achieved, ultimately
leadingtoefficientstraight-through-processing,singleviewof
customer, integrated liquidity and risk management, all-
encompassingfrauddetection,andglobalpaymentmanage-
mentsolution.Allthiswithalowcostapproachofimplement-
ingthepaymenthubinfrastructure,becauseabankcangrow
its payment center in a value-based and affordable manner
overtime.
The solutionA bank payment hub is the most practical and future-proof
systemtomatchabank’sobjectivesandrolloutapproach.It
isacomponent-basedpaymentsarchitecturecompliantwith
thelatesttechnologystandards.Thedifferentelementsofthe
architecturearebusinessprocessmanager,businessservices,
28 - The Journal of financial transformation
29
Over the past 30 years the payments industry has grown
increasingly more complex, creating unwieldy silos within
banks. In the developed world Automated Clearing Houses
(ACH)werecreated toprocess low-valuepayments thatare
enteredthroughavarietyofchannels, includingchecksand
other paper instruments, telephone, file transfer, branch,
Internet,ATMandso forth.Oftenthesechannelshavetheir
own infrastructure to process these payments correctly
before they are forwarded to the Clearing House for settle-
ment.Furthermore,theseACHpaymentsvaryfromcountryto
countryandusedifferentproprietaryformats.
Theintroductionofhigh-valuepaymentssystems,calledReal
TimeGrossSettlement,madeitpossibleforpaymentstobe
cleared in real-time or near real-time. Although they have
significant overlap with ACH payments, with regard to the
processesthatareapplied,ithasunfortunatelynotprevented
banksandClearingHousesfromcreatinganotherwholenew
setofinfrastructures,tohandle,forallintentsandpurposes,
thesamepayment.AswiththeACHpayments,multiplechan-
nelsareusedtoenterRTGSpaymentsintothesystem.
BothACHandRTGSaredomesticpaymentsystemsandwere
notcreatedtohandlecross-bordertransactions.Inresponse,
anumberofthebankscreatedSWIFT,TheSocietyforWorld
International Funds Transfer, which is a secure messaging
infrastructurethatworksontheprincipleofcorrespondents.
ASWIFTmemberbankoffersaccessto localclearingfor its
overseas correspondent banks, and vice versa. Once again,
although in essence a cross-border payment enables an
accounttobedebitedandananothertobecredited,albeit,
foraccountsthatareheldindifferentcountriesanddifferent
currencies,acompletelyseparateinfrastructurehasbeencre-
atedwithinbankstohandlecross-borderpayments.Aswith
ACH and RTGS payments, there are a variety of channels
available to thecustomer to initiatecross-borderpayments,
whichonceagainduplicatedmoreinfrastructures.Inaddition,
duetothenatureandcomplexityofthepaymentinstructions
oftenalargebackofficestaffwasneededtomanuallyenter
andrepairpayments.
Whilst the world of bank payments was evolving from low
valuethroughtohighvalueandcross-border,atotallydiffer-
entindustryandinfrastructurewasforminginparallel,cards.
Initially card associations were limited to processing credit
transactions, but that has been extended to include debit
transactions attached to a debit account. Within a financial
institution,itistypicalforthecardsdivisiontobecompletely
separatefromanyoftheotherpaymentsdivisions.Thisledto
thecreationofotherseparateinfrastructurestohandlepay-
ments via credit and debit cards, using other standards for
processingofthecardpaymenttransactions.Whenonecon-
sidersthispictureitisnothardtounderstandthatalthough
banksgenerate35%ofallrevenuesthroughpayments,they
also incur around 40% of their total cost, according to the
BostonConsultingGroup.
The challengeTheend-resultofthisevolutionisthatpaymentssystemsare
siloed, resulting inahugeamountof infrastructureduplica-
tion, both hardware and software, and becoming a severe
maintenance headache. Systems are dated, difficult to sup-
port,andinmanycasesrunningontechnologyplatformsthat
areunsupportedorwillbe inthenearfuture. Infrastructure
duplication has not been limited to technology, but also
involvesstaffemployedtoensuresmoothprocessingofnon-
STPpaymentsandtomonitorandmaintaintheinfrastructure.
Theseissuestranslateintoavarietyofchallengesforbanks,
suchasmakingchangestopaymentsystemsquickly,provid-
ingcustomerswith informationaboutthepayment lifecycle,
to process payment related information such as purchase
orders,invoices,andremittanceadvices,tohaveanintegrated
viewofthecustomer,andbeingabletotrackpaymentsend-
to-end.Silosrequiresimilarchangestobemadeinmorethan
oneplaceandincreasethecostofownership.
Intoday’sworldoffranticcompetition,banksneedtheflexibil-
itytobeabletooffernewcompetitiveproductstotheircus-
tomersquickly.Moreandmore,thisrequiresthebankstech-
nologyplatformstobeconfigurable,flexible,andadaptableto
dations that occur prior to a payment being passed to the
payment hub and passes them to the BPM with flags that
indicate what rules have been applied to the payment. This
allows the BPM to determine the workflow entry point and
businessservicesthatneedtobeappliedtothepayment in
ordertocompletetheprocessingofthepayment.
ByusingthisapproachofCAAs,itiseasiertomigrateexisting
functionality from existing channels into the payment hub.
Whenfirstimplementingapaymenthub,itislikelythatexist-
ingchannelsalreadyperformsomeoftherequiredpayments
processing.
Inthisscenariothepaymenthubeitherdoesnotneedtopro-
videallpaymentprocessingortheworkflowcanbeconfigured
suchthattheprocessingalreadyperformedinthechannelsis
notperformedagaininthepaymenthub.Inthelongerterm,
itisrelativelyeasytomigratethefunctionalitypresentinthe
channelintothepaymenthub.Thefunctionalityinthechan-
nelcanbeswitchedoffandtheworkflowinthepaymenthub
canbeextendedtoincludetheprocessingpreviouslycarried
outinthechannel.
channel aware submitterChannelawaresubmitters(CAS)aresimilartoCAAs.Thedif-
ferencebeingthattheysubmitpaymentsfromthepayment
hub to external systems for processing. These external sys-
temsrangefromotherbanksystems(suchasthehost),truly
externalsystems(suchasthelocalACHorRTGSsystem),the
SWIFT gateways, and the customer delivery channels. The
submittersareresponsibleformappingthepayments intoa
formatexpectedbythetargetsystemandtheyalsohavetobe
abletoaddordeleteinformationthatisexpectedbythedeliv-
erychannel.Agoodexampleofthisisanysecurityhandshake
thatwouldneedtooccurforauthenticationpurposesbetween
twoexternalsystems.
conclusionUsingacorepaymentsengine,abankachievesitsobjective
to operate an intelligent central transaction hub that man-
ages all payments transactions originating from all of the
bank’se-channelsandbranches.Byadoptingasystemthatis
services as well as components-based, they migrate over
timeandattheirownpacetoafuture-proofplatformthatis
thecenterofallpaymentflowsindependentofwherethedif-
ferentcomponentsoperateorwhowroteordevelopedthem.
Abstractingandrationalizingthebusinessprocessfromthe
channelsyieldsimmediatebenefitsthatimproveoperational
efficiency.Thechannelawareprocesses,bothadaptersand
submitters,allowthebanktoshieldtheunderlyingprocesses
fromthechannelsand tobecomeflexible inacceptingnew
channels. Future developments are not only made at their
ownpacebutarealsovendorindependent,becausethesolu-
tionallowsthebanktodeveloptheirchangesandnewcom-
ponents in-house. Thus making it easier to react to new
developingbusinessneedsthatpresentafavorablebusiness
case.
30 - The Journal of financial transformation
dataaccesslayer,channelawareadapter,andchannelaware
submitter.Standardcomponentsmustbedeliveredtogether
withatoolkitthatabankcanusetoextendthefunctionality.
Business process managerAbstracting the workflow and business process from the
underlying business services, offers the necessary flexibility
requiredtorolloutacomponent-basedpaymentarchitecture.
The business process manager (BPM) is at the heart of the
paymenthubandperformsthekeyrolesofworkflowandbusi-
nessprocessmanagement.TheBPMhasnoprocessingcapa-
bility.Whenapayment is receivedby thepaymenthub, the
BPMidentifiesthetypeofpaymentandcallstheappropriate
workflowandrelatedbusinessprocesses.
Ifanewbusinessprocessstepneedstobeaddedtothework-
flow,forexamplecateringforanewregulation, it isdoneat
the BPM layer without any change to the existing business
services.Likewise,ifabusinessservicewritteninanoldtech-
nology needs to be replaced, this is done so without any
changestotheBPM.Havingthiscapabilityinsulatesthepay-
mentsystemarchitecturefromfuturechangesthatcannotbe
plannedforatthedesignanddevelopmentstage,trulyoffer-
ingtheoftencalledfortime-to-marketandflexibilitybenefits.
Business servicesBusinessservicesarediscretecomponentsthatexecuteunits
ofwork.Thecomponentsareservicestobeusedwhenpro-
cessingmanydifferentpaymenttypesviadifferentchannels.
TheBPMinvokescomponentsorprocessestoperformcertain
tasksintheorderdeterminedbytheBPM.Thesecomponents
arecontextless,whichmeansthattheyhavenoknowledgeof
theworkfloworprocess.Theyreceivearequestwithassoci-
atedparameters,performtheirtask,andreturntheresultto
theBPM.Providedthattheexistingbankapplicationsadhere
totheinterfacelayerdefinedbytheBPM,itispossibletore-
useexistingcomponentsthatarealreadyutilizedwithinthe
bank’s environment. Similarly, it is possible to use existing
third-party components if they support the interface of the
BPMoriftheycanbewrappedtosupportit.
data access layer Thedataaccesslayer(DAL)isthelogicalinfrastructurelayer
that the payment hub sits on. The business services access
thedatathroughtheDAL,whichdescribesthedataelements
thatresidewithinoneormorephysicaldatabases.TheDAL
usesdataresidentwithinthepaymenthubandaccessesinfor-
mation retrieved from sources outside. There can be data
elementsthatarenotdirectlypayment-relatedthatneverthe-
lessneedtobeaccessibleinordertoprovideforend-to-end
paymentsprocessing.
Ifpartofthebusinessprocessistocheckthelimitsandthe
account information is held on a host, the business service
invoked by the BPM will retrieve the account limit for the
specified account number. The business service expects a
standard logical data model, part of the payment hub that
defineswherelimitsdataisretrievedfrom.TheDALservices
thedifferentbusinessserviceswiththedatatheyrequire,and
performs the actions required to get information from the
outsideworlditself.
AswiththeBPMlayer,theDALneedstobeabstractedfrom
itsphysicalimplementationinordertoprovideinsulationfrom
future changes and from diverse implementation environ-
ments.Inevitablytherearechangestothephysicaldataloca-
tionanditisimportantthattheydonotnecessarilyhavean
effectontheBPMandbusinessservices.Similarlyitisneces-
sarytoallowchangestotheBPMandbusinessservicesthat
have no effect on the logical or physical deployment of the
DAL.
channel aware adapters Thechannelawareadapters(CAA)manageontheonehand
thespecificsof thechannel,which range fromaweb-based
channel,anIVR,message-basedreal-timepaymentsorlarge
file-based batch payments, basically across all the different
communicationand transportprotocols thatexist in today’s
fragmentedpaymentsworld.
Ontheotherhand,theCAAmanagesthepre-processingvali-
31
Emerging models
Payment systems and regulation
Hans geigerProfessor, The Swiss Banking Institute,
university of Zurich
Fritz KleinIndependent Consultant, and Chairman,
CLS Holdings/CLS Bank International
Abstract
Paymentsandpaymentsystemsareanimportantfunctionof
banksandthebankingsystem.Financial intermediation, the
coreroleofthebankingindustry,canbedividedintocapital
andpaymentintermediation.Alothasbeenanalyzed,written,
andsaidaboutcapitalintermediation,itsbalancesheetrelat-
ed risk management and regulation. Risk management and
regulationrelatedtopaymentsystemsisanewertopic.This
article points out sources of risk in payments and payment
systemsandanalysestheapproachtoregulation.
33
Payment systems and regulation
Thetermfinancialintermediationisgenerallyusedtodescribe
thefinancialserviceindustry’sroleasamiddlemanbetween
theultimatesaversandborrowers.Wecallthisfunctioncapi-
tal intermediation. In addition, a second sphere of financial
intermediation exists, which can be described as payment
intermediation. It stands for the financial function of the
middlemanbetweenthepayerandthepayeeasthemonetary
componentinamarkettransaction.AccordingtoMertonand
Bodie,‘clearingandsettlingpayments’isoneofthesixcore
functionsperformedbyafinancialsystem.Althoughpayment
intermediationisalesspopularsubjectthancapitalinterme-
diation,itplaysanequallyimportantroleinoureconomy.Itis
thegoalof thispaper tomakeacontribution toourunder-
standingoftherisksandrewardsofpaymentintermediation,
andtodiscusswhetheritshouldberegulatedandsupervised,
andifso,howthisshouldbedone.
Paymentintermediationishighlyimportantfortheeconomic
wealth of the world. Without the use of effective payment
mechanisms,today’sdivisionof laborthroughmarkettrans-
actions would be impossible, Adam Smith’s invisible hand
couldnotperformitsvitalrole,andtheworldwouldremain
stuckinaprehistoric,self-supplyingeconomy.Inthiscontext
itisinterestingtolookbackontheoriginofbankinginEurope.
The driving force behind the development of the financial
system of pre-industrial Europe was not lending per se, but
payments[Kohn(2001)].Inthemedievaleconomy,mosttrade
tookplacewithinlocalcommunitiesofpeoplewhoknewone
another well, and such trade was largely conducted on the
basisof trust.Thesubsequentdevelopmentof tradeamong
strangersindifferentlocationsintroducedanewchallenging
task,whichwastoovercomeanonymityandthedifferencesin
time and distance. This task required new methods of pay-
ment that did not depend on spatial proximity and mutual
acquaintancebetweenthepayerandthepayee.Thetwoprin-
cipalfinancialinnovationsofpre-industrialEurope,thedepos-
itbankandthebillofexchange,evolvedtoaddressthisneed
and moved the banks into their present intermediary role,
substitutingthecounterpartyinthepaymentprocessbothfor
thesellerandthebuyer[McAndrewsandRoberds(1999)].
Becauseamultitudeofbanksexist intoday’sword,allnon-
cash payments for transactions, where the buyer and the
sellerdonothavetheiraccountswiththesamebank,trigger
secondarytransactionsbetweenthebanksofthepayerand
the payee. These secondary transactions are processed
throughstreet-sideorinter-banksystems.Today,street-side
systemsareattheveryheartofeffectiveandefficientpay-
ments. There are three basic architectures for organizing
suchsystems,thenetwork,whereallbanksmaintainbilateral
accountrelationshipswitheachother(aspecialcaseofthe
network is the correspondent banking system, where some
banks act as special nodes in the network and serve other
banks),thecentralizedclearingandsettlementorganization,
which serves as a hub for all the banks (the clearinghouse
collects the payment transactions of all the banks over a
certainperiodoftimeandcalculatesanetpositionforevery
bank. Upon settlement the clearinghouse debits or credits
the participating banks with the net amount of all transac-
tions),andthereal-timegrosssettlementsystem,analterna-
tive central solution, where the payment transactions are
continuouslychargedandcreditedtotheaccountsthatthe
participatingbanksmaintainwiththecentralsystem.Thetwo
systemswithacentralizedarchitectureareoftenoperatedor
closelysupervisedbyacentralbankandserveasatransmis-
sionmechanismformonetarypolicy.Thecentralizedsystems
havetraditionallybeenorganizedbyeachindividualcountry
andbycurrency,whichmade internationalpayments ineffi-
cient, costly, and risk-prone. International payments still
depend largelyonthedecentralizedcorrespondentbanking
system.
Theenormousinnovationsininformationandtelecommunica-
tiontechnologiesoverthelastfewdecadesledtothecollapse
oftimeanddistance,thetwophysicaldimensionsthatareat
thehistoricrootsofthebankingsystem.Yet,thecollapseof
distancedoesnotmeanthatgeographydoesnotmatterany
more.Besidesdistance,geographyhasmanydimensionsthat
affecttradeandpayments,suchaslaws,customs,language,
anonymity or familiarity, education, and history or path
dependence.Technologicalinnovationswillresultinafurther
34 - The Journal of financial transformation
Payment systems and regulation
35
reduction of transaction costs and may even include the
emergenceofanewtypeofmoney,digitalmoney.Suchdevel-
opmentscouldchallengetheveryroleofbanksaspayment
intermediaries.
Paymentsandtheirregulationarethusnotonlyimportantfor
theeconomyasawhole,butalsoforthefutureofbanks,both
inaglobalandlocalcontext.Paymentservicesareonearea
wherebanksstillenjoysignificantadvantagesoverothercom-
petitors,not leastbecauseof theiraccess to thestreet-side
systemsandthecentralbank.Sincebanksarechallengedat
many fronts in capital intermediation, their role in payment
systemsmightbecomeanimportantfactorforfuturesuccess
or failure. It would be dangerous to assume that the past
advantagesofbanksinpaymentserviceswillsurvivenaturally
and remain unchallenged [Llewellyn (1999)]. Banks, both as
individual firms and as an industry group, must, therefore,
clarifyandpossiblyredefinetheirroleandstrategyinthearea
ofpayment intermediation.Suchastrategymustdetermine
the role of cooperation and competition within the industry
andtowardsthecustomersandnewcompetitors.Indoingso,
itwillheavilyinfluencetheroleofregulationandself-regula-
tionintheareaofpaymentintermediation.
Similarlythegovernments,centralbanks,andbankingsuper-
visors must make sure that regulation or deregulation pro-
motestheworkingsoftheinvisiblehandbyfurtherreducing
the costs and risks of exchange transactions, while at the
same time maintaining and enhancing the soundness and
stabilityofthepaymentsystems.
Risk and risk management in payment systemsThe risks of modern payment systems stem from the chal-
lenge that trade between strangers in different locations
introducedintotheworldoftrade.Riskanalysisinpayments
andpaymentsystemsmustgoalong the lineof the trading
andpaymentprocess.Ingeneral,theprocesscanbesimplified
asfollows.Thepaymentprocessisinitiatedwiththeunderly-
ingdealingphasebeingconcluded.Fromthispointonwards
fivetypesofriskarise.
market risk — The risk that market prices change until the
business transaction is fullyconcluded.This isprimarily the
resultofthebusinesspracticethatatransactionisconcluded
ondayA(‘tradeday’T)andsettled(fulfilled)ondayB,sev-
eral days later (T+x). Of course, there is no guarantee that
settlement will really take place. Such a gap quite naturally
existsinforwardtransactions,butthereisalsoagapoftwoor
threedaysinnormalcashtrading[usuallytwodays(x=2)in
foreignexchangespotdealingandthreedaysincashsecuri-
tiesdealing].Thistypeofmarketriskdoesnotconstitutepart
of the payment phase, but rather of the preceding dealing
phase.ItcanbereducedbyintroducingaCentralCounterparty
(CCP)intothebusinessprocessorbyeliminatingthetimegap
betweendealingandpayment.TheCCPwithitsriskmitigating
structurewillsignificantlyreducetheriskthatsettlementwill
notsubsequentlyoccur.Thereductionofthetimegapreduces
theprobabilityandtheextentofmarketpricechanges.
credit risk —Theriskthatonepartyfulfillsitssideofthebusi-
nesstransaction(delivers)andtheotherpartydoesnot(coun-
terpartyorsettlementrisk).Counterpartyorsettlementrisk
canbeeliminatedbyintroducingdeliveryversuspayment,a
paymentprocesswherebothsidesoffulfillmentareconduct-
edsimultaneously.Ifonesidedoesnotdeliver,theotherdoes
notpayandviceversa.
liquidity risk —Ifonepartyfulfillsontimeandtheotheronly
withdelay,thenliquidityriskarisesintheformofthecostof
financing the resulting gap. For the payment system as a
wholetheliquidityriskisparamount.
operational risk — During the whole dealing and payment
process a variety of other risks exist which we summarize
undertheterm‘operationalrisk‘.Thisincludeshuman,techni-
cal,process,aswellaslegalrisk.
Reputational risk — Problems in the payment function can
also be the source of reputational risk for a bank, which
manifestsitselfinareductionoffuturegrowthandearnings
potentials.
Therisksinthelaterstagesofthedealingprocessarerelated
directlytopaymentsystems,theirstructureandtheirdesign.
Thepaymentprocesscanonlyberegardedasfullyconcluded
once the receipt of the payment is reconciled. This is the
point-in-time where the recipient has full knowledge of the
payment received. In managing all the risks involved, there
arethethreebasicoptions,eliminatingtherisk,mitigatingit,
or passing it on to another party. The general operational
natureofrisksinpaymentsisunderlinedbythefactthatthere
isanoptionofeliminatingrisk.Thisdistinguishestheserisks
from other business related risks, such as loan granting,
whereeliminationisonlypossiblebynotconductingthebusi-
nesstransactioninthefirstplace.Figure1detailsthedifferent
risksandthepracticalpossibilitiestomanagethem.
Inaddition,inpaymentsystemsthephenomenonofsystemic
riskisimportant.Itresultsfromthefactthatanyoftheabove
riskscanspreadacrossapaymentsystemfromonepartici-
panttoanother,infectingparticipantsofthepaymentsystem
thatwerenotconductingbusinesswiththeoriginalsourceof
a problem. The structures and processes of the street-side
systemsaredecisivefortheprobabilityandtheconsequences
ofsystemicfailuresthatexhibitsimilaritieswiththespreadof
diseasesthroughcontagioninbiologicalsystems.
Payment systems and regulation
36 - The Journal of financial transformation
management action Elimination mitigation Pass-on
credit risk
Riskofone-sidedpayment •Deliveryversuspayment •Settlementlimits •Paymentafterconfirmedreceipt
•Settlementmonitoring •Paylate
•Fastreconciliation
Riskofrevocationofpaymentreceived •Legalconceptoffinality
Riskofaparticipantnotmeetinghisoverallpayment •Real-timesettlement •Morefrequentsettlementcycles •Carefulselectionofdirectmembership
obligationattheendofasettlementcycle •Settingofparticipantlimits inpaymentsystem
•Meetingthe‘Lamfalussyprinciples’for
netpaymentsystems1
Riskoflossofbalancecreatedbypaymentreceived •Settlementincentralbank •Nostrolimits
money •Nostromonitoring
Countryrisk/transferrisk •N/a •Countrylimits •Inter-marketswaps
•Countrymonitoring
liquidity risk
Riskofinsufficientliquidity •Fastaccesstoliquidity
(e.g.duetounexpectedpaymentoutflows) (i.e.intradayrepoprocedures)
•Maintenanceofreservecollateral
Riskofnotreceivingincomingpaymentsplannedfor •Monitoringofpaymentflow
•Real-timeinformation
•Fastreconciliation
Riskofstrainofliquiditybylargesettlementvalues •Nettingconcepts
Riskofstrainonliquiditybylargepayments •Splittingofpayments
Riskofdeadlock(blockingofcross-directional •Circlesprocessing(simultaneous
paymentsduetolackofliquidityingross settlementofcompensatingpayment
paymentsystems) flows)
legal risk
Riskofrevocationofpaymentsreceived •Legalconceptoffinality
Riskofconflictsoflaw(netting) •Grosssettlement
Riskofconflictsoflaw(cross-border) •Carefulwordingofcontracts
•Externallegalopinions
Riskofcontractsnotbeingupheldincourt •Carefulwordingofcontracts
•Externallegalopinions
1 ReportoftheCommitteeonInterbankNettingSchemesofthecentralbanksof
theGroupofTencountries,BIS1990.
Payment systems and regulation
372 Paymentsystemsrequireagreementsbetweenfinancialinstitutionsthatcompete
witheachotherforcustomersinthepaymentmarket.Theseagreementsmaybe
inconflictwithcompetitionlaw.
3 Thismayespeciallybethecasecombinedwithconflictswithcompetitionlawor
whenrisksarecontractuallypassedontoclients.
4 Operationalrisksusuallyexistbothonthelevelofthestreet-sidesystemandof
criticallyimportantparticipantsofthepaymentsystem(theinterruptionofacriti-
callyimportantparticipantmaybringtheentiresystemtoahalt).
Figure1:Riskandriskmanagementinpaymentsandpaymentsystems
Riskofconflictwithcompetitionlaws2 •Eliminationofvolumediscounts
•Openaccesscriteria
•Vettingofcontractualagreements
Riskofconflictwithconsumerprotectionlaws3 •Vettingofcontractualagreements
•Transparentproductdescriptions
•Simpleandtransparentpricestructure
operational risk4
Riskofsystembreakdown •Dualdesignofalltechnicalcomponents •Contractualpass-ontoclients
•Businesscontinuityprocedures
•Regularrehearsals
Riskoflossofdatacentreoroperationalcentre •DualsitesforIT&operations •Contractualpass-ontoclients
(e.g.terrorism,epidemic) •Inter-bankalarmorganization
•Businesscontinuityprocedures
•Regularrehearsals
Riskoflossoftelecommunicationlinks •Dualtelecomlinesfromdifferentproviders •Contractualpass-ontoclients
•Replacementcommunicationprocesses
•Regularrehearsals
Riskofcorrupteddataand/orsoftware •Independentreplacementsoftwarewith •Contractualpass-ontoclients
reducedfunctionality
•Permanenttechnicalcontrolprocedures
•Softwaredevelopmentprocedures
•Testing
Riskofunforeseenevents •Operationalproceduresforexception •Contractualpass-ontoclients
handling
•Inter-bankalarmorganization
•Regularrehearsals
Riskoffraud(external) •Technicalmessageauthentication •Insurance
•Useofstrongencryptiontechniques •Contractualpass-ontoclients
•Authorizationchecks
•Measuresagainstcounterfeiting
•Vigorousprosecution(includingthe
internationallevel)
•Provisionof7x24hotlinestocustomers
•Customerawarenesscampaigns
Riskoffraud(internal) •Four/sixeyeprocedures •Insurance
•Vigorousprosecution
Riskofclericalerrors •Technicalplausibilitychecks •Insurance
•Four/sixeyeprocedures
compliance/reputational risk
Riskofprocessingpaymentswitha •Knowyourclientprocedures •n/a
criminalbackground •Technicalmonitoringofpayments
(e.g.fortriggerwords)
Riskofbreachofconfidentiality •Dataencryption •n/a
•Definitionofrulesforhandlingofdata
•Contractualpass-ontoclients
Riskofconflictwithcompetitionlaws •Eliminationofvolumediscounts •n/a
•Openaccesscriteria
•Vettingofcontractualagreements
Riskofconflictwithconsumerprotectionlaws •Vettingofcontractualagreements •n/a
•Transparentproductdescriptions
•Simpleandtransparentpricestructure
Riskofnegativepressreports •CarefulPR •n/a
management action Elimination mitigation Pass-on
why regulation?Banksareregulatedandsupervisedinpracticallyeverycor-
neroftheworld,althoughthereisnoconsensusinacademia
onwhyandhow.Thegeneralargumentonanabstractlevel
is thatregulationshouldcompensateforthemarket failure
thatwouldprevailinasituationwithoutregulationandsuper-
vision. Market forces alone will not necessarily achieve the
objectiveofefficiencyandsafetysufficiently,becauseapar-
ticipantdoesnotnecessarilybearall thecostsandrisksor
thereisatimelagbetweenthebusinessopportunity(profit)
andtherisk(cost)arising[BIS(2001)].Theothersideofthe
coinistheriskofgovernmentfailure.Regulationofeconomic
activities always faces the challenge of balancing between
thetwoextremesofmarketorgovernmentfailure,orinthe
languageofthenewcomparativeeconomicsbetweendisor-
deranddictatorship[Djankovetal.(2003)].
Thethreespecificmotivationsforregulatingbanksarethe
protection of individuals, primarily the banks’ customers,
guaranteeingthefunctioningofthesystem,andprotection
againstsystemicrisks.Thenotionofsystemicriskstandsfor
the danger that problems in a single financial institution
mightspreadandthat,inextremesituations,suchcontagion
coulddisruptthenormalfunctioningoftheentirefinancial
system.Inspiteofthefactthatsystemicriskandcontagion
aresuchimportantmotivesforregulation,itisstrikinghow
littlethis isreflectedinregulatorysystems.Regulationand
supervisionarestillprimarilydirectedatavoidingthefailure
of individual banks. An illustration of this fact is the new
Baselproposaloncapitaladequacy,BaselII,whichstatesas
itsprimarygoaltostrengthenthesoundnessandstabilityof
thebankingsystem.TheBaselproposaltriestoachievethis
by exclusively regulating one aspect of individual banks:
Solvencyintheformofcapitalrequirements.Liquidityisnot
evenmentionedintheBaselproposal.Usingtheanalogyof
the health system, solvency can be viewed as the physical
fitnessofthepeoplewithinapopulation,whereasliquidity
plays the role of vaccination. To protect a society against
theriskofadisease,vaccinationismoreimportantthanfit-
ness.
Itisobviousthatprudentialregulationandfinancialstability
are still two very different spheres with little connections
between the two, other than that the second serves as an
argumentforthefirst.Thefactthatcreditandliquidityrisks
inherentinpaymentandsettlementsystemshavethepoten-
tial to contribute to systemic problems makes the third
motiveforregulatingbankssoimportantforoursubject.
How to regulatePayments can be regulated on the three levels, payers and
payees, banks, and inter-bank systems. Regulation is by its
very nature a national task, although the international or
cross-border dimension has become a major concern with
respect to effectiveness and systemic risk of payment sys-
tems.Onthefirstlevelwelookatthetwooriginalpartiesofa
markettransaction,i.e.thebuyerandtheseller,orthepayer
and the payee. Such regulation affects all natural and legal
personsinajurisdiction.Theserulesarealsorelevantforthe
actors on the second and third level, discussed below. The
most important legal frameworks are property rights, the
criminal code, the commercial and bankruptcy law. These
basic legalframeworksarenotspecifictopaymentsystems,
but they are most important for the functioning of an
exchange economy, which is based on market transactions
and payments for such transactions. Examples of activities
thatareregulatedinthecriminalcodeandthatarecrucialfor
paymentsarefraudandmoneylaundering.
Importantaspectsofpaymentsthatareregulatedinthecom-
merciallawarethedefinitionoftime,place,identification,and
themeansofpaymentthatareessentialforapaymenttrans-
action. Where has the transaction to be completed, at the
location of the payer or the payee? Is the payment legally
completedatthetimethepayerhastransferredthevalueor
atthetimethepaymenthasreachedthepayee?Hasthepay-
mentobligationbeendischargediftheamountiscreditedto
theaccountatthepayee’sbank?Anaspectthathasbecome
decisive for the realization of the Continuous Linked
Settlementsystemfortherisk-freesettlementofforextrans-
actionsisthequestionoffinalityandconditionality,whichis
Payment systems and regulation
38 - The Journal of financial transformation
Payment systems and regulation
39
influencedbybankruptcyregulationsinallcountriesinvolved
inapaymenttransaction.Alltheseregulatoryframeworkson
the first level are supposed to be clearly defined and well
establishedinthelegalsystemofdevelopedcountries.They
arenotalwaysworkingwellindevelopingcountries,andcon-
flicts still arise in cross-border payments between countries
with different legal systems and commercial practices. The
decreeofthefinalitydirectivebytheEuropeanUnionin1998
wasanimportantsteptowardsanopenpaymentareawithin
the E.U.5 Internationally, the establishment of the United
NationsCommissiononInternationalTradeLaw’s‘UNCITRAL
ModelLawon InternationalCreditTransfers’ in 1992wasan
essentialstepformakingfirstlevelrulescompatiblebetween
differentcountries.
Regulation on the second level concerns the banks in their
roleaspaymentintermediaries.Itcantaketheformofpublic
regulation or ruling by the government or a supervisory
authority,oralternatively the formof self-regulationby the
bankingcommunity.Thereareanumberofreasonsforbanks
toregulatetheiractivitiesthemselves.Oneistoavoidpublic
regulation. Other important incentives for self-regulation in
theareaofpaymentsresultfromthefactthatpaymentsys-
temsexhibitstrongnetworkexternalities.Theneedtoprocess
andchannelpaymentsefficientlythroughdifferentbanksand
thestreet-sidesystemrequirestechnicalandbehavioralstan-
dards, both for transactions between different banks and
betweenbanksandtheircustomers.Self-regulation,andpub-
licregulation,alwayspossessesacertainriskofmonopolistic
impacts.Thusantitrustlegislationisoneimportantaspectof
regulation on the second level. At the same time, contracts
concludedbybankswiththeircustomersmaycontainaspects
of abuse of power, thus leading to demands for consumer
protection.
Today, the regulation of payment systems is predominantly
basedontheprudentialregulationofthebanks,althoughthe
arguments for banking regulation and supervision are not
primarilyorientedtowardthepaymentfunction.Contraryto
deposit taking, the payment function does not constitute a
legalreasonforsupervision.InSwitzerland,asinmanyother
European countries, the public postal service is the market
leaderinretailpayments,butitisnotsubjecttosupervision
bythebankingauthorities.Ingeneral,theregulationofpay-
mentscanbeseenasaby-productofgeneralbankingregula-
tion.Someexceptions to thiscanbe found in theEuropean
Union.Onewastheearlyadoptionofacommonpositionby
theE.U.fortheintroductionofaseparateprudentialsupervi-
sory regime for electronic money institutions in 19996.
Anotherarea is the regulationoncross-borderpayments in
the Euro-zone, which has so far not (yet) achieved a single
paymentareafornon-cashpaymentsintheinternalmarket,
despitetheexistenceofacommoncurrencyarea.TheE.U.has
takenandiscontinuingtotakeregulatoryactionstoachieve
thisimportantgoalbecausethemarketforcesdonotprovide
incentivesforafastandeffectivemodernizationoftheE.U.-
widepaymentinfrastructures.
Capitaladequacyrulesarethefirstpillarofprudentialsuper-
vision,andtheregulationofliquidityplaysasecondaryrole.
Theliquidityaspectofregulationismorecloselylinkedtothe
role of the central bank than to the prudential regulator. In
manycountriesthecentralbankhasnotonlythecontrolover
money,butalsotheultimateauthorityoveraccessofbanks,
andother intermediaries, tocentralbankmoneyand to the
national inter-bank system.Theprovisions in thenewSwiss
NationalBankLawthatmandatesthecentralbank‘toprovide
forthe liquidityoftheSwissFrancmoneymarket, tosupply
theeconomywithcash,tofacilitateandsecurethefunction-
ingofthepaymentsystem,andtocontributetothestability
ofthefinancialsystem’areanexampleforsuchanextended
role.7
The third level of regulation, relating to the inter-bank or
street-side systems, covers the most important aspect of
financialstabilityrelatedtopayments.Inordertobeeffective,
regulationandsupervisiononthethirdlevelmustcoverboth
national and international aspects, because contagion does
notstopatnationalborders.In1990thecentralbanksofthe
group of ten, G10, countries created the Committee on
5 Directive98/26/EConSettlementFinalityinPaymentandSecuritiesSettlement
Systems.
6 CommonPosition(EC)No8/2000,adoptedbytheCouncilon29November1999.
OfficialJournaloftheEuropeanCommunities,28.1.2000,p.C26/1.
7 NBGofOct.22003,Art.5.
Payment systems and regulation
PaymentandSettlementSystems(CPSS)withtheaimofana-
lyzingdevelopmentsindomesticandcross-borderpayments,
and settlement and clearing systems. In its analysis, the
Committeepaysparticularattentiontofinancialstability,and
therebytothelinkagesbetweeninstitutions, infrastructures,
andmarkets.TheCommitteehasdefinedsevenareasofwork,
among them the core principles for systemically important
paymentsystems,theuseofcentralbankmoneyinpayment
systems, and retail payment instruments and systems. With
regardtofinancialstability,thedevelopmentofthe‘coreprin-
ciples’ is themost importantactivityof theCommittee.The
workontheprinciplesstartedin1998andwascompletedin
January2001[BIS(2001)].Thecoreprinciplesdonotconsti-
tute legallybinding regulation; theyare intended foruseas
guidelinestoencouragethedesignandoperationofsafeand
efficient payment systems worldwide. They define the key
rolesandtheresponsibilitiesofcentralbanksinapplyingthe
principles. The principles have a similar role as the Basel
frameworkonInternationalConvergenceofCapitalMeasure-
ment and Capital Standards for prudential supervision. And
thecentralbanksaretheorchestratorswhowillpromotetheir
implementation.
Thecentralbanksshouldensurethattheirownsystemscom-
plywiththecoreprinciplesandtheyshouldhavetheabilityto
overseecomplianceofthosepaymentsystems,whichtheydo
notoperatedirectly.Itisalsotheresponsibilityofthecentral
bankstocooperatewithoneanotherinpromotingthesafety
andefficiencyofpaymentsystems.Thetenprinciplesstate,
among other points, that the assets used for settlement
shouldpreferablybeaclaimonthecentralbank,whichfacili-
tates the role of central bankers to fulfill the expectations.
Another principle states that payment systems should have
clearly defined procedures for the management of the two
mostimportantrisks,creditandliquidity.Coreprinciplenum-
ber IV requires finality on the day of value, preferably even
duringtheday.ThisisaclearindicationthattheCPSSprefers
themodel‘Real-TimeGrossSettlement’(RTGS)withcontinu-
oussettlementtothe‘ClearingHouse’modelwithmultilateral
nettingandfundingattheendoftheday.PrinciplenumberIX
demands objective and publicly disclosed access criteria, to
secureacompetitivemarketfortheparticipatingbanks.Itis
alsoevidentthattheCPSSrecommendationsfavorpayment
systemsthatprocessdebitandcredittransferselectronically
ratherthanmanuallyandonpaper.Forsystemsusingpaper-
based instruments, such as cheques, there are difficulties
involvedinsatisfyingsomeofthecoreprinciples.
It canbeconcluded that theCommittee’s recommendations
are highly dependent on recent technological innovations.
RTGSandelectronicpaymenttransferswerenotyetavailable
justtwodecadesago.Technologyisattheveryheartofprog-
ressinpaymentsystems.Understandingandusingnewtech-
nologies properly seems more important for the efficiency
and stability of payment systems than the formalities of
whether oversight is implemented by legislation, by regula-
tors,bytheauthorityofcentralbanks,orbyself-regulation.
Masteringtherisksresultingfromthedifferencesintimeand
spacerequirestheskilleduseofnewtechnologies,overcom-
ingtherisksofanonymityandbuildingasolidfoundationof
confidenceandtrustrequiresstandards,rules,andauthority
thatwarranttheproperuseofthattechnologybythepartici-
pants.
References• BankforInternationalSettlements,CPSS(2001),CorePrinciplesforSystematically
ImportantPaymentSystems,Basel.
• Djankov,S.,E.L.Glaeser,R.LaPorta,F.Lopez-de-Silane,andA.Shleifer,2003,The
NewComparativeEconomics,NBERWorkingPaperSeries,WorkingPaper9608.
• Kohn,M.,2001,PaymentsandtheDevelopmentofFinanceinPre-IndustrialEurope,
Hanover,NH.
• Llewellyn,D.T.,1999,TheNewEconomicsofBanking,Amsterdam:SUERFSociété
UniversitaireEuropéennedeRecherchesFinancières.
• McAndrews,J.,andW.Roberds,1999,PaymentIntermediationandtheOriginsof
Banking,FederalReserveBanksofNewYorkandAtlanta.
40 - The Journal of financial transformation
Emerging models
why has stored-value not caught on?
sujit chakravorti1Senior Economist,
Federal Reserve Bank of Chicago
Abstract
Why have general-purpose stored-value cards been unsuc-
cessfulinpenetratingtheU.S.market?Threenecessarycon-
ditions for a payment instrument to be successful are dis-
cussed:consumersandmerchantsneedtobeconvincedofits
advantages over existing payment alternatives for at least
sometypesoftransactions;paymentprovidersmustconvince
consumers and merchants simultaneously of its benefits to
achievecriticalmass;andassurethemthatadequatesafety
and security measures have been implemented. This article
discussesthecreditcardindustry’ssuccessinmeetingthese
necessaryconditionsandgeneral-purposestored-value issu-
ers’failuretomeetthemtodate.
411 IthankVictorLubasiandLeonardoMayerfortheirexcellentresearchassistance.
Theviewsexpressedaretheauthor’sandshouldnotbeattributedtotheFederal
ReserveBankofChicagoortheFederalReserveSystem.
why has stored-value not caught on?
wepay.Thesefourmajorinnovationsare:coins(4,000years
ago), checks (800yearsago),papermoney (more than 100
yearsago),andthepaymentcard(over50yearsago).
Threeimportantconditionsmustbemetbeforestoredvalueis
widelyused.Firstly,consumersandmerchantsneedtobecon-
vincedthatstoredvalueissuperiortoexistingpaymentinstru-
ments forcertain typesofpayments.Generally,storedvalue
paymentssubstituteforcashpayments.Storedvaluehasbeen
asuccessfulalternativetocashinclosedloopsystems,suchas
transportationservicepurchases,coffeepurchasesatcertain
popular coffee chains, and for purchases on university cam-
pusesandmilitarybases.Nilson(2003)estimatesthatprepaid
cards, which include stored-value cards for limited use and
phone cards, accounted for U.S.$55 billion in 2003 and pre-
dictsthatthisfigurewillgrowtoU.S.$146billionin2007.
Secondly,aswiththeintroductionofanynewpaymentinstru-
ment, to achieve critical mass, consumers and merchants
needtobeconvincedsimultaneously.Thatis,consumerswill
notusestoredvalueunlessasufficientnumberofmerchants
accept it and merchants will not accept it until a sufficient
numberofconsumersuseit.Anexampleoftheinabilityofa
payment instrumenttoovercomethechicken-and-eggprob-
lemistheSusanB.Anthonydollarcoin.Becausecoinsremain
incirculationmuchlongerthanbills,theyarelessexpensive
for currency issuers toprovide in the long run.Unlikemost
countries,theUnitedStateshasbeenunsuccessfulinreplac-
ing lower denomination bills with coins. McAndrews (1997)
arguesthatCanada,likeothercountries,waseventuallysuc-
cessfulwithitsdollarcoinbecausethecentralbankstartedto
withdrawnotesfromcirculation.
Thirdly,withanypaymentinstrument,consumers,merchants,
andfinancialinstitutionsareconcernedwithcreditandfraud
risk.Forourpurposes,creditriskistheriskthatthepayeeis
unabletoconvertapaymentintogoodfunds.Theinabilityto
acquire good funds may result from the payer, a payment
intermediary,ortheissuer’sinabilitytoprocessormakegood
onitsobligationtodeliver.Fraudriskistheriskthatanunau-
thorizeduserisabletousethepaymentsystemforfinancial
gains or a participant in the payment process presenting a
monetaryclaimthatisnotbackedbythevaluestated.
Animportantissuewithcreditandfraudriskistheallocation
ofmonetarylosseswhenitoccurs.Consumersandmerchants
preferthattheliabilitylieswiththepaymentserviceprovider.
Paymentinstrumentswiththischaracteristicmayalsopene-
tratethemarketquicker.Inthecaseofcreditcards,govern-
ment regulations determine the maximum liability to the
consumerifthecardisusedbyanunauthorizeduser.Today,
thecardnetworkshavefurtherreducedtheconsumer’sliabil-
ityforunauthorizedusetozero.
is it better? Fornewpaymentproductstosucceed,theyneedtoprovide
benefitstobothconsumersandmerchants,whileatthesame
timebeingprofitableforpaymentprovidersinthelongrun.3
Issuersofnewpaymentinstrumentsusuallytargetasegment
ofthepaymentservicesmarketwheretheirproductissupe-
rior toexistingalternatives.Arecentexampleofapayment
productthathasbenefitedbothconsumersandmerchantsis
thepaymentproductprovidedbyPayPal.comtobuyersand
sellersfortransactionsononlineauctionssitessuchaseBay.
Because many relatively small merchants were not usually
equipped to process credit and debit card transactions and
checkswereassociatedwithhighsettlementrisk,apayment
enablerlikePayPal.comwasabletointermediatethesetrans-
actionsresultinginbothpartiesbeingbetteroff.
credit cardsIn the early 1970s, some financial observers predicted that
creditcardswerenotviableinthelongrun.Onesuchobserv-
er argued that credit cards were ‘a temporary but probably
unavoidable retreat in the campaign to develop an efficient
domesticpaymentsmechanism’[Hester(1972)].Today,credit
cardtransactionsranksecondbehindchecksintermsofthe
numberofnon-cashtransactionsintheUnitedStates.4There
were 17.86 billion general-purpose charge and credit card
transactions accounting for U.S.$1.608 trillion in the United
2 General-purposestored-valuepaymentcardsaredefinedasthosethatarewidely
adoptedbymerchantsandconsumerswherethevalueresidesonthecardandis
transferredtothemerchant’sterminalatthetimeofpurchase.Unlessotherwise
stated,stored-valuecardswillbeshortforwidely-acceptedstored-valuecardsin
thisarticle.
42 - The Journal of financial transformation
why has stored-value not caught on?
43
Advancesincomputingpower,electronics,andtelecommuni-
cations have improved the way we live. Now such advances
have started to change the way we pay. Technological
advancements now make it possible for consumers to pur-
chasegoodswithelectronicbitsofinformationrepresenting
money,commonlyreferredtoasstoredvalue.Thevaluemay
bestoredonmicrochipsembeddedinplasticcardsthatlook
similar to credit cards. This type of stored value device is
calledasmartcard.Accordingtoanarticlesevenyearsago,
‘Smart cards are set to revolutionize payment systems and
provideaplethoraofnewopportunities’[TalmorandTimewell
(1997)].Anotherarticleinthepopularpressstatedthat‘Cash
isdirty,inefficient,andobsolete.Smartcards,digitalcashand
ahostofelectroniccurrencieswillsoonreplacepocketmoney’
[Gleick(1996)].Thisarticleasksthequestion:Whyhavegen-
eral-purposestored-valuecardsnotbeenwidelyadoptedas
someanalystshadexpected?2Iwillcomparethecreditcard
industry’ssuccessinmeetingthreeconditionsnecessaryfor
widespreadadoptionwiththestoredvalueissuers’failure in
meetingtheseconditionstodateintheUnitedStates.
Financialanalystshavepredictedthedeathofcashandother
paper-based payment instruments for many years. Cash
usage has started to decline. According to an American
BankersAssociation/DoveConsultingStudy,cashusagehas
declinedfrom39percentto32percentforin-storepayments
[Sapsford (2004)]. Part of this decline results from greater
acceptanceofpaymentcards,suchascreditanddebitcards,
at merchant locations that traditionally had not accepted
them.IntheUnitedStatesandmostpartsoftheworld,limit-
ed-usestored-valuecardshavebeensuccessfulascashsub-
stitutesforsomenichemarkets,suchastransportationsys-
tems,universitycampuses,andmilitarybases.
Smart card issuers along with producers of the technology
havemadesizeableinvestmentstoestablishsmartcardsasa
viablepaymentinstrument.Themigrationtochipcardsfrom
magneticstripeoneshavebeenaidedbythereductioninthe
cost of producing smart cards. Payment card organizations,
such as MasterCard and Visa, along with banking and non-
financial institutions have invested significant amounts of
money into stored-value technology in an effort to provide
electronic substitutes for government-issued physical cash.
MasterCardreportedlyhad investedoverU.S.$150millionto
purchase 51 percent of Mondex International, an electronic
cash system developed in the United Kingdom by National
Westminster Bank [Hansell (1998)]. National Westminster
spentmorethanU.S.$100milliondevelopingMondex[Stouffer
(1996)].
Stored-value issuershope toearn interest fromoutstanding
stored-valuebalances,earnfeesfrommerchants,andpossibly
revenuesfromadvertisingonthephysicalcard.However,issu-
erswillhavetoconvinceconsumersandmerchantswhythey
should use stored value. Issuers argue that their product
wouldbemoreconvenientforconsumersandreducecostsof
processingpaymentformerchants.
MostanalystsagreethatthetwolargestU.S.stored-valuetri-
als, theAtlantaOlympicGamesandtheUpperWestSideof
Manhattan,failedinconvincingconsumersandmerchantsof
thebenefitsofusingstoredvalueoverexistingpaymentalter-
natives.TheEconomist(1998,73)concludedthat,‘Electronic
money has thus turned out to be a solution in search of a
problem.’ While general-purpose stored-value has not been
successful in the United States, many European countries
have implemented such payment instruments with varying
degreesofsuccess.Thisarticlewilladdresssomefactorsthat
haveleadtoadoptionofstored-valuepaymentinstrumentsin
somecountriesbutnotothers.
The necessary conditionsConsumersandmerchantsarereluctanttochangetheirpref-
erencestowardspayment instruments. Inthecontextof the
issuance of new coinage, Jevons (1875) wrote, ‘No one can
possiblyunderstandmanysocialphenomenaunlesshecon-
stantlybearsinmindtheforceofhabitandsocialconventions.
This isstrikinglytrueinoursubjectofmoney.’Furthermore,
EvansandSchmalensee(1999)observethatinthelast4000
yearstherehavebeenonlyfourmajorinnovationsintheway
3 ChakravortiandKobor(2003)arguethatpaymentproductsmaynothavetobe
profitableasastand-aloneproduct,butsufficientlyaddvaluetoabundleofbank-
ingandpaymentservices.
4 Incertainpaymentsegments,suchasin-storepurchases,creditcardshavesur-
passedchecks.Inothermarketsegments,suchasInternetpayments,creditcards
continuetobethepreferredpaymentinstrumentalthoughsignature-baseddebit
cardshavestartedtocatchup.However,forrecurringbillpaymentandbusiness-
to-businesspaymentscheckscontinuetomakeupthelion’sshareofpayments
[ChakravortiandMcHugh(2002)andChakravortiandDavis(2004)].
5 ChakravortiandEmmons(2003),ChakravortiandShah(2003),andChakravorti
andTo(1999)discusstheincentivesforconsumerstousecreditcardsandmer-
chantstoacceptthem.
6 Inadditiontosecurityconcerns,foreigntravelersmayneedtoconverttheircash
intolocalcurrencypriortomakingpurchasesandconverttheremainingforeign
currencybacktohomecurrencyattheendoftheirtrips.However,sometypesof
transactions,especiallysmallones,mayrequirecashforpayment.
7 Foradiscussionofpaymentinstrumentcost,seeFoodMarketingInstitute(2000).
why has stored-value not caught on?
Consumers are unlikely to use stored value for purchases
wheretheyusechecks,creditordebitcardsbecausetheyrisk
losingmonetaryvalueifthestoredvalueislostorstolenand
forgo the opportunity to earn interest on their funds before
theyspendthem.8EvidencefromScandinaviancountriessug-
gests that greater penetration of debit cards especially for
low-value transactions has resulted in greater reluctance to
use stored value products [Van Hove (2004)]. Thus, stored
value may only replace a shrinking number of cash transac-
tions.
Oftensuccessfuladoptionofastored-valuecardisassociated
witheliminatingalternativepaymentmethodscompletely. In
theDutchcitiesofPrumerend,Nijmegen,andRotterdam,the
useofChipknip,ageneral-purposestoredvaluepaymentsys-
tem, became the only way to pay for street parking. As a
result,parkingaccountedfor31percentofthetotalnumberof
Chipknip payments [Van Hove (2004)]. Stored-value cards
mayalsobecometheonlypaymentoption forsomeFrench
parkinglots.
Merchantsmaybenefitfromalowervolumeofcashtransac-
tionsbecausetheyaremorepronetosafekeepingconcerns
and on average take longer to perform than stored-value
ones.Lucas(1994)statesthatemployeetheftcanaccountfor
upto4percentofcashsalesforprimarilycash-basedtransit
systems. In addition, some merchants would benefit from
quickertransactionsbecausethetransferbetweenthemer-
chant’sstored-valuemachineandtheconsumer’ssmartcard
would be faster than alternative payment forms [Poon and
Chau(2001)].
However,merchantsmaybethemostreluctanttousestored-
valuetechnology.Merchantsmayfacelargetransitioncostsin
acquiringthenecessaryhardwaretoacceptstoredvalueand
trainingtheirstaff.Someanalystsarguethattheinitialinvest-
mentmayberelativelysmallcomparedtothepotentialcash
savings,especiallysinceacceptanceterminalsforotherpay-
mentcardswouldneedtobereplacedovertime.Whenthese
terminalsarereplaced,theycouldbefittedforacceptanceof
storedvalueatrelativelylowcost.
44
why has stored-value not caught on?
Statesin2002[Nilson(2003)].
General-purposechargeandcreditcardshaveexistedforover
40years.Unlikechargecards,creditcardsallowedconsumers
to pay their monthly charges in installments. Today, credit
cardsbenefitconsumersandmerchantsandareprofitableto
paymentproviders.5Creditcardsservetwoprimaryfunctions
forconsumers,theyallowconsumerstopurchasegoodsand
services (serves as a payment instrument) and they extend
credit to consumers lacking sufficient funds even if they
choosetopaytheirbalancesinfull(servesasacreditinstru-
ment). Consumers may also prefer to use their credit cards
becauseoffrequent-useawardsordispute-resolutionservic-
es.Furthermore,consumerscanusethemalmostanywherein
theworld.Asaresult,creditcardsmaybepreferredtocash
or travelers’ checks as a secure, widely accepted payment
instrumentforforeigntravelers.6
Although the credit card is the most expensive payment
instrument to accept, merchants benefit from credit card
acceptance, justifying their relatively high cost.7 For charge
and credit card purchases, most merchants enjoy payment
guaranteesfromcardissuersiftheytaketheproperauthori-
zation steps. Merchants also benefit from greater sales and
profits.Inasurveyofretailers,83percentthoughtaccepting
credit cards increased sales and 58 percent thought their
profits increased from accepting them [Ernst and Young
(1996)]. These greater sales are generated in part because
consumersmaynothavesufficientcashonhand.
Financial institutions earn revenue from the merchant dis-
count, interest income from consumers who borrow beyond
the payment cycle, and other fees from additional services
provided. However, there are risks that financial institutions
take when issuing credit cards. Investment in new payment
productsmaynotimmediatelygenerateapositivereturn.In
thecaseofBankofAmerica,fifteenmonthsafter launching
itsBankAmericard,itofficiallylostU.S.$8.8milliondollars.If
hiddencosts,suchasadvertisingandoverhead,wereincluded
thelosswasclosertoU.S.$20million[Nocera(1994)].
stored-valueLimited-use stored value systems have been successfully
adopted for transportation systems, such as the Bay Area
RapidTransitsystemintheSanFranciscoBayAreaandthe
Metro intheWashingtonD.C.area.Sometransitauthorities
have introducedsmartcards thatcanbeusedasproximity
paymentdevices.InHongKong,thetransitauthoritieshave
introducedsmartcardsasthesolepaymentdeviceandhave
foundthatmorepassengerscanbeprocessedinagiventime
spanresultinginreducedqueues[PoonandChau(2001)].
TwonotableU.S.general-purposesmartcardtrialswerecon-
ductedduringthelast8years,UpperWestsideofManhattan
andtheAtlantaOlympicGames.Bymostaccounts,thesetri-
alswerenotsuccessfulbasedontheusageratesandthelack
of long-term adoption in the United States. However, some
lessons can be learned. In both trials, consumers and mer-
chants were given incentives to use the product. In the
Manhattan trial, converted laundrymachinesaccounted for
30percentofalltransactionsconductedwiththestored-val-
ue cards [Van Hove (2001)]. In Atlanta, stored-value cards
were more successful when merchants did not previously
acceptpaymentcards,suchasfast-foodrestaurantsandcon-
venience stores [Bank Systems & Technology (1996)].
Therefore, stored value cards are popular with consumers
andmerchantsatmerchant locations thathad traditionally
acceptedonlycash.
Similartocreditcards,forstoredvaluetobesuccessful,con-
sumersandmerchantsalongwith financial institutionmust
allperceiveabenefit fromitsuse.A lucrativenichemarket
segment forstored-valuecardsareunmannedpointofsale
purchases, such as vending machines, parking meters, and
faresfortransportationservices.Akeyissueforconsumers
in such purchases is the availability of exact change. Coca-
Cola estimates that a significant portion of their potential
salesnever tookplacebecausecustomersdidnothavethe
exactchange[Clemons,Croson,andWeber(1997)].Inother
cases,consumersmayoverpayforservices,suchasparking
andtolls.
458 Forageneraldiscussionaboutthepreferredpaymentinstrumentbyconsumers
andmerchants,seeChakravorti(1997)andHumphrey,Pulley,andVesala(1996).
9 ForadiscussionabouttheinterrelateddemandforpaymentservicesseeBaxter
(1983).
10 SeeEconomidesandHimmelberg(1995)foradiscussionofcriticalmassinthe
contextofnetworkgoods.
why has stored-value not caught on?
and issued cards to applicants if they had a job. Because
cardholdersinitiallydidnotincuranyofthecostsassociated
withcreditcardtransactions, theywereeasilyconvincedto
usethecards.
Cardissuershadmoredifficultybringingmerchantsonboard
becausethemerchantswerechargedafractionof thepur-
chaseprice.DinersClubmanagedtoconvincetwelverestau-
rantownerstoaccepttheircardatthetimeoflaunch.Bank
of America started with 300 merchants. Larger merchants
wereunwillingtopaythemerchantdiscount.Thefirstlarge
departmentstorechaintoacceptthird-partycreditcardswas
J.C. Penney in 1979 and widespread acceptance by grocery
storeshasonlyoccurredrecently.Ontheotherhand,smaller
merchantsthatgrantedtheircustomerscreditwerewillingto
paythefeetoreducetheiraccounting,collection,andbilling
costs.
To expand the geographic coverage of its cards, Bank of
America began to license the BankAmericard through Bank
America Service Corporation to out-of-state banks. Banks
wouldpayaU.S.$25,000entryfeetoBankofAmericaanda
small royalty to support a national advertising campaign to
becomemembersofthenetwork.Eachbankwouldenlistits
ownmerchantsandcustomers.Themaingoaloftheselicens-
ing agreements was to increase the number of consumers
using the card and the number of merchants accepting the
card.BankofAmericabenefitedfromBankAmericardholders
fromotherstatesmakingpurchasesfromtheirmerchantsand
from their customers making purchases from merchants of
theirlicensees.
Card issuers used innovative ways to simultaneously con-
vince consumer and merchants of the cards’ benefits. The
moreconsumersthatcardissuersconvinced,themoremer-
chantswerewillingtoaccept it.Althoughcreditcardswere
eventually successful in overcoming the chicken-and-egg
problem, Osterberg and Thomson (1998) argue that critical
masswasonlyachievedinthelateeightieswhenitsgrowth
exploded.
stored-value Topromoteusage,paymentinstrumentprovidersenticeboth
consumersandmerchantswithincentives.Inthetwolargest
U.S.general-purposestored-valuetrials,issuersgaveconsum-
ersmonetaryvaluetopromoteitsuse.AttheAtlantaOlympic
Games,somestored-valuecardsweregivenawaywithfivedol-
lars of purchasing power, but cardholders preferred to keep
themassouvenirs. InNewYork,Citibankemployeeshanded
out cardswithU.S.$5ofvalue topassersby.Merchantsalso
received the necessary equipment at subsidized rates and
maynothavepaidthefullmerchantdiscount.
Toincreaseawarenessofsmartcardtechnology,somefinan-
cialinstitutionsinothercountrieshavestartedtouseexisting
payment instruments, suchasATMandcreditcards, topig-
gybackstoredvaluebyplacingmicrochipsonthesecards.For
example, financial institutions in Belgium and Finland have
started to put microchips on ATM cards. In these countries,
consumersmustusestoredvaluetopayforparkingmeters,
calls from public phones, and bus tickets [The Economist
(1998)].Theseusesofstoredvaluemayincreaseconsumers’
awarenessandcomfortlevel.
is it safe and secure? The sustainability of a new payment instrument is critically
dependenton thecontainmentofcreditand fraudrisk.The
success of any payment system is related to the faith and
confidence that participants have in it. Payment providers
shouldconvinceconsumersandmerchantsthattheycancon-
verttheirclaimsintogoodfundswithminimalrisk.Ifthepay-
ment provider becomes bankrupt and has payment obliga-
tions outstanding, consumers and merchants may face sig-
nificantlosses.Tolimitcreditrisk,someEuropeanregulators
have argued that stored value should be only provided by
regulatedfinancialinstitutions.
Alongwithcreditrisk,paymentprovidersareconcernedwith
containing fraud risk. Roberds (1998) describes two major
formsoffraud.Inthefirstcase,thebuyerpresentsamone-
taryclaimthatisnotbackedbythevaluestated.Forexample,
46 - The Journal of financial transformation 11 Foranexcellentdiscussiononwhythedebitcardhasbeenslowtopenetratethe
marketplaceseeCaskeyandSellon(1994).
12 Recently,around5millionU.S.retailerssettledacaseagainstMasterCardand
Visaoverthetyingofassociationcreditanddebitcardproducts.Aspartofthe
settlement,thecardassociationscannolongertietheircreditanddebitcard
products.FormoreaboutthiscaseseeChakravorti(2003).
why has stored-value not caught on?
Financial institutions should also benefit from the shift to
stored-value from cash. The migration to electronic substi-
tutes for cash may provide greater profit opportunities for
financial institutions in terms of cost reductions associated
withsecurityandtransportation.Inaddition,financialinstitu-
tions may benefit from income generated from issuing and
distributing the stored value and the interest income from
outstandingstoredvalue.
can it achieve critical mass?Paymentinstrumentshavetwodistinctsetsofusers,consum-
ers and merchants, that simultaneously demand payment
services. Consumers benefit more from an increase in the
number of merchants that accept the payment instrument
thanfromanincreaseinthenumberofconsumersthatuseit.
Similarly, merchants benefit more from an increase in the
numberofconsumersthatarewillingtouseitthanthenum-
berofmerchantsthatacceptit.Inotherwords,theconsum-
er’sandthemerchant’sdemandforthepaymentserviceare
interrelated.9 These types of services are often called two-
sidedbecauseusageoftheseservicesisdependentonboth
sidesbeingonboard.
Paymentservicescanbeviewedasnetworkgoods.Agoodis
definedasanetworkgoodifauserbenefitsfromanincrease
in the number of users of that good [Farrell and Saloner
(1985),andKatzandShapiro(1985)].Forexample,telephones
andfaxmachinesarenetworkgoodsbecauseexistingusers
benefit froman increase in thenumberofpeople that they
can communicate with. Furthermore, a sufficient number of
usersisrequiredforthenetworkgoodtosurvive.Economists
definethissufficientnumberasacriticalmass.10Bothcredit
cards and stored value exhibit characteristics of network
goods.
Theproblemofanetworkgoodachievingcriticalmasscanbe
described as a chicken-and-egg one. An example of a good
that required a long time to overcome the chicken-and-egg
problemisthedebitcard.Althoughthefirstdebitcardpilot
wasconductedin1966,onlymanyyearslaterdiddebitcard
transactionsstarttogainpopularity.11Onetypeofdebitcard,
commonly referred to as PIN-based, uses ATM networks to
processtransactionsatthepointofsaleandisalsoanATM
card. Issuerswere initiallyunsuccessfulatconvincingasuf-
ficientnumberofmerchantstoparticipateprimarilybecause
oftheadditionalcostofinstallingcardreadersandthelack
ofinteroperabilityamongthedifferentATMnetworks.Today,
oneinthreemerchantshaspoint-of-saleterminalsneededto
processPIN-baseddebitcards[Nilson(2003)].Furthermore,
consolidation of ATM networks and the introduction of
sharednetworksalsoincreasedtheappealofPIN-baseddebit
cardstomerchants.
Another debit card innovation that allowed greater market
penetrationwastheintroductionofthesignature-baseddebit
cards issued by the credit card associations. These debit
cardsuse theexistingcredit cardnetwork infrastructure to
processandsettletransactions.Becausecreditcardnetworks
were already extensive and merchants faced no new setup
costs, thesecardswereable topenetrate themarketmuch
quicker.Inaddition,topromoteacceptanceofthesignature-
based debit cards, the card associations required all mer-
chants accepting their credit cards to accept their debit
cards.12
Toovercomethechicken-and-eggproblem,debitcardprovid-
ers used existing technologies that were familiar to both
merchants and consumers. To increase consumer usage
many financial institutions started to issue ATM cards that
werebothPIN-basedandsignature-baseddebitcards.Thus,
with the ATM customer base and the use of the existing
credit card network by signature-based debit cards, debit
cardswereabletoovercomethechicken-and-eggproblem.
credit cardsCharge and credit card issuers used various techniques to
overcomethechicken-and-eggproblem.Toachieveacritical
massofconsumers,BankofAmericamailedactivecardsto
their existing customers. Not having a customer base to
solicit,DinersClubinitiallyhandedoutleafletsdoortodoor
47
13 Today,NBIisknownasVisa.
14 AnotableexceptionistheMondexsystemwhichallowsconsumerstoexchange
valueamongthemselveswithoutthird-partyintervention.Formoredetailsabout
MondexseeClemons,Croson,andWeber(1997).
why has stored-value not caught on?
stored-valueThe most powerful deterrent against fraud in stored-value
systems is the technology. Smart card technology may be
moresecurethancashformerchantsandofferissuersgreat-
erprotectionfromcounterfeitersthanmagneticstripetech-
nology.TopreventtheftofcoinsfrompublicphonesinFrance,
callers were required to use smart cards. The major credit
cardcompaniesareconsideringsmartcard technologyasa
replacementformagneticstripestoreducecreditcardfraud.
Stored-value issuers want to limit or perhaps eliminate the
possibility that outsiders can replicate the underlying value
andinjectitintothesystem.Oneofthelargestknowncases
where a stored-value system was compromised occurred in
JapaninvolvingPachinkoparlors,wherethelesssecuremag-
neticstripetechnologywasused.Criminalorganizationswere
abletocreatestoredvaluethattheydidnotpurchase.Asa
result stored-value issuers are said to have lost at least
U.S.$600million[Pollack(1996)].
Realizing that themostsophisticated technology toprevent
fraudmaynotbeimpenetrable,stored-valueissuersarecon-
sidering other preventive measures. While online real-time
verification would defeat the purpose of stored value, most
issuersrequireredemptionoftheunderlyingvalueaftereach
use.14Inthesesystems,fraudcouldbedetectedsoonerthan
in systems where stored value is redeemed less frequently.
However,giventherelativelysmallamountofmonetaryvalue
transactedwithstoredvalue,theremaybelittleincentiveto
commitfraud.
will stored-value succeed?Giventhecomfortandconveniencethatconsumershavewith
existingpayment instrumentsandongoing improvementsto
reducethecostofacceptingthem,consumersandmerchants
in the United States may perceive little benefit from stored
valueasastandalonepaymentinstrument.Thus,unlesscon-
sumersareforcedtouseitbymerchants,thewidespreaduse
ofstoredvalueasastandalonepoint-of-salepaymentinstru-
mentisunlikelyintheUnitedStates.However,microchipsare
beingaddedtoidentificationcardsorexistingpaymentinstru-
mentswherevaluecanbestoredandusedtomakepurchases.
Suchtypesofcardsexistinclosedsettings,suchasuniversity
campuseswherestudentsmayusethestored-valuefeatureto
makephotocopieswhereotheralternativesarenotasconve-
nient. Alternatively, merchants using stored value in closed
systems, such as transportation systems, could enter into
agreementswithothermerchantstobroadentheacceptance
ofthepaymentinstrument.
Toachieveacriticalnumberof consumers for storedvalue,
financialinstitutionsmayofferastored-valueenhancementto
theirexistingdebitandcreditcards.Similartothedebitcard,
whereissuersusedtheexistingATMandcreditcardnetworks,
bypiggybackingonexistingpaymentcards,storedvaluecould
benefit from economies of scope. While in many European
countries, financial institutions replacedexistingdebit cards
with ones with stored value capabilities, Van Hove (2004)
states thatmanyof theseunsolicitedstoredvalueenhance-
mentsremainlargelyunused.Therefore,whilesuchastrategy
maybehelpfulinachievingacriticalmassofpotentialusers,
itisclearlynotasufficientconditionforwidespreadadoption.
Experiences in Europe suggest that government mandates
may increase theacceptanceofsmartcards.However,even
withsuchintervention,usageratesofthestored-valuecom-
ponentremainsmallasapercentageoftotaltransactions.As
with the introduction of other payment instruments, stored
valuecardswillrequiresometimebeforetheyachievecritical
mass.WhileVanHove(2004)arguesthatstoredvaluehasnot
todateachievedthedesiredmarketpenetration,heidentifies
certain types of merchants as ideal candidates for stored
value.Thesetypesofmerchantshaveatleastoneofthefol-
lowing characteristics: payments are time-critical (public
transport), there are high cash handling costs (vending
machines),ortherearevandalismproblems(parkingmeters
andpayphones).
48 - The Journal of financial transformation
why has stored-value not caught on?
inachecktransaction,theconsumermaywritecheckswith
insufficient funds in his account. The other type of fraud
involvesthebuyerusingamonetaryclaimbelongingtosome-
oneelse.
Whilecreditandfraudrisksaredifficult,ifnotimpossible,to
eliminate,adequatedisclosureofwhichparticipantbearsthe
lossiscriticaltothesustainabilityofanypaymentinstrument.
Ifpaymentproviderscannotadequatelyguardagainstunau-
thorized use, resulting losses may lead them to leave the
industry and lead consumers and merchants to lose confi-
denceinusingthattypeofpaymentinstrument.Furthermore,
ifconsumersandmerchantsperceivethattheyaremorelia-
bleforpaymentsmadewithanewinstrument,theymaybe
lesswillingtouseit.
credit cardsHistorically,creditandfraudriskshavebeenchallengingfor
creditcardissuerstocontainandhaveledtoanumberofissu-
ers leaving thebusiness.Technological advancementsalong
withgovernmentregulationssignificantlyreducedtheserisks.
However,creditcardnetworkscontinuetoimproveandintro-
ducenewmeasurestomitigatetheserisks.
Creditrisksarecontainedbyguidelinesandrulesatvarious
levelsinthecreditcardnetwork.Theriskthatafinancialinsti-
tution isunabletomeet itspaymentobligation iscontrolled
primarilybythecardassociations.Becausethecostoflosing
theirreputationissohigh,theassociationsimposeguidelines
governingthedistributionoflossesifamemberinstitutionis
unabletomeetitsobligations.Creditriskattheconsumerand
merchantlevelisprimarilycontainedbypoliciesofthefinan-
cial institutions involved. Today, financial institutions use
more rigorous methods to determine creditworthy consum-
ers.Inaddition,partoftheinterchangefeeschargedbycard-
issuers to merchant banks covers the credit risk the issuer
facesfromconsumersunabletopaytheirobligations.
Fraud was a major factor in the early years of charge and
credit cards. Evans and Schmalensee (1993) report that in
1960,BankofAmerica’slossesfromfraudanddefaultswere
nearlyU.S.$9millionor15percentoftheirvolume.Fraudwas
committedinvariousways,includingconsumersusingcards
tomakepurchasesthattheydidnotintendtopayfor,cards
beingstolenfromthemailandusedtomakepurchases,and
merchantssendingincreditslipsfornonexistentpurchases.
Banksimplementedseveralpoliciestolimitfraudulentuses.
Banksrequiredthatmerchantscalltheirfinancialinstitution’s
creditcenterswhenpurchaseswereaboveacertainamount,
knownas floor limits.Manybanksprovidedmerchantswith
hot lists that identified delinquent accounts. Eventually,
Congressoutlawedthemailingofunsolicitedcreditcardsby
financial institutions in an effort to limit fraudulent use.
However,thesemeasureswerenotsufficient.
Theuseofcomputersandtelecommunicationsintheautho-
rizationprocessallowedcreditcardorganizationsandtheir
memberstocontainfraud.In1972,NationalBankAmericard,
Inc. (NBI), thecreditcardorganizationspunoffbyBankof
America,introducedanationwidenetworklinkingcomputers
via telephone lines toauthorizecreditcard transactionsat
thepointofsale.13AlthoughthesystemcostU.S$3millionto
build and implement, it saved members of NBI at least
U.S.$30million in the firstyear [Nocera (1994)].The initial
authorization system still involved humans checking com-
puter screens for the status of the customer’s account.
Today,theprocessiscompletelyautomatedandmosttrans-
actions are authorized prior to purchase. Further improve-
mentstothephysicalcard,thenetwork,andthemonitoring
of charges have led to significant reduction in losses from
fraud.
Althoughcreditandfraudriskhavenotbeeneliminated,suf-
ficientstepshavebeentakentoassureconsumersandmer-
chantsthattheyfaceminimalliabilitywhenusingandaccept-
ing credit cards. The adoption of system wide guidelines
alongwiththeaidofreal-timeonlineprocessinghasgreatly
reducedtheserisksinthecreditcardnetwork.
49
why has stored-value not caught on?
conclusionThisarticleexploredthreenecessaryconditionsfortheviabil-
ityofanewpaymentinstrument.Anewpaymentinstrument
maytakelongerforconsumerstoacceptbecauseofthecom-
plexsetofinteractionsthatoccuramongparticipants.Itmust
provide benefits not provided by existing ones for at least
certaintypesoftransactions.Consumersandmerchantsmust
beconvincedsimultaneouslyof itsbenefitsandmayrequire
incentives to change their behavior. Finally, the payment
instrumentshouldberelativelysafeandadequatemeasures
againstcreditandfraudriskshouldbeadopted.
While credit cards were successful in meeting these three
necessary conditions, stored-value cards have yet to meet
them. However, in markets where limited-use stored-value
cardshavebeensuccessful,theyaregenerallyasubstitutefor
cash.Theyarepopularwithconsumerswhenexactchangeis
required. In some cases, as with the dollar coin, significant
market penetration may not occur unless consumers are
forcedtoadoptstoredvalue,suchaspaymentoftransporta-
tion services and parking fees. They are popular with mer-
chantswhencashhandlingcostsarehighandotheralterna-
tivesarenotavailableforpayment.Today,themostsuccessful
limited-use stored value operators have started to leverage
theirexpertisetoexpandacceptanceoftheirproductbeyond
itsinitialuse.TheOctopusstored-valuesysteminHongKong
was expanded from payment for transportation services to
includepurchasesatnon-transitrelatedmerchants.Theintro-
ductionofanewpaymentinstrumentrequiressufficienttime
to educate consumers and merchants of the benefits of
migratingfromexistingpaymentoptions.Ifstoredvalueisto
succeed,bothconsumersandmerchantsmustbeconvinced
ofitsbenefits.
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50 - The Journal of financial transformation
Emerging models
online payments systems for e-commerce1
caroline PaunovConsultant, OECD
graham VickeryHead of the Information Economy unit, OECD
Abstract
Withtheslowuptakeofe-commerce in thebusiness-to-con-
sumer(B2C)sector,theinitialhighlyoptimisticgrowthpredic-
tions of e-commerce soon came to be revised downwards.
Withthegaininmaturityofe-commercetherehasbeenarise
insuitableproductsforonlinesalesandsometrendtowards
increased consumer confidence. For these positive develop-
ments to finally lead to the long-expectedgrowth inmarket
share,thingswillcruciallydependupontheexistenceofwell-
developed online payment solutions for e-commerce. This
articleaimstobrushsomebroadconclusionsonthisissue.
Afirstobservationisthatdespitetheexistenceofavarietyof
payment means credit cards are the dominant system for
online money transfers. This is a consequence of advanta-
geouscharacteristics,most importantlythe long-established
51
networks and wide user-bases. However, traditional credit
cardpaymentshavedeficitsintheareasofsecurityandano-
nymity. Moreover, the payment means is not ideal for auc-
tions and micropayment markets. Alternative systems in
somecountriesaredebitcardsandpaymentsviaonlinebank-
ing.Givenlimiteduserbases,electroniccashisnotafeasible
paymentoption.Incontrast,themediatingservicePayPalhas
been successful particularly in serving the auction market.
Furthermore, largeuserbasesandhighaccessibility render
mobile devices as potentially important future means for
conductingpayments. Inparticular, theymay,togetherwith
Internetoptions,playanimportantroleinprovidingmicropay-
mentsolutions.Forthesepayments,thereisstillawaytogo
toestablishaclearalternative to thenon-optimalsubscrip-
tionmodel.
1 Theviewsexpressedinthisarticledonotnecessarilyrepresenttheviewsofthe
OECDoritsmembergovernments.
online payments systems for e-commerce
ofallanalyzedwebsites.Animportantaspecttobearinmind
is the divergence of importance of payment means across
countries.Figure1showsthatforindividualcountries,asfor
instanceFinland,otherpaymentsystems,notablydebitcards
butalsoe-bankingfacilities,arealsoofimportance.
Advantages of credit cardsThe dominant market position of credit cards is easily
explained by their distinguishing characteristics. The long-
establishednetworkcombinedwithawideuser-baseconsti-
tutesaveryimportantadvantage.Thisfactorgainsparticular
significanceintheonlinemarket,becauseitisinitsnaturea
network infrastructuremarket thatprovidesaplatformthat
permits money transfers between the buyer and seller. As
such, the payment system’s value rises with the size of its
user-base, both on the buyer and the seller sides. Further
benefitsarisefromestablishedpresenceandconsumerexpe-
rience with the payment means as well as established and
clearperspectivesonliability.Afurtherkeyadvantageliesin
the existing international dimension of credit cards, which
permitpaymentsacrossnationalborderseasily.Theseadvan-
tageseffectivelyconstitutethebasisforastrongmarketposi-
tion,whichalternativepaymentmethodswillhavetoprovide
andcompetewith.
security of credit card paymentsDespite their widespread use and acceptance, traditional
onlinecreditcardpaymentshavedeficitswithrespecttothe
securityoftransactionsbecauseofweakauthenticationand
the necessity to transfer detailed financial information for
payment3.Asaresult,fraudratesforonlinecreditcardtrans-
actions are higher than for payments through the offline
channel. Yet the losses to fraud are not currently assuming
alarmingnumbers.However,householdsurveysacrossOECD
countriesconstantlyfindthatsecurityconcernsarekeyfac-
torsexplainingconsumerunwillingnesstouseonlinepayment
instruments.Togiveoneillustration,PaymentOnesurveydata
suggestthatnearlythreeoutoffourU.S.consumersdonot
usecreditcardpaymentsonlinebecauseofsecurity (Figure
2). And this is particularly related to providing credit card
informationonline.
52 - The Journal of financial transformation 2 ThesurveywasconductedbyPricewaterhouseCoopersonbehalfoftheEuropean
Commission.Forthestudy,613websiteswereanalyzedmostofwhichwere(454)
e-commercesitesandtheremaining(159)e-bankingsites.Thefocusoftheanaly-
sisisonsecurityaspectsofpaymentsystemsprovidedone-commercewebsites.
online payments systems for e-commerce
53
Withtheslowuptakeofe-commerce,particularlyinthebusi-
ness-to-consumer (B2C) sector, the initial highly optimistic
growthpredictionssooncametobereviseddownwards.Asa
consequence of these developments, attention started to
focusontheobstaclestoe-commerce.Importantly,astrong
barrier to B2C market growth, which surveys continuously
showed,wasstrongconsumerconcernoveronlinepayments.
Atpresent,withthegaininexperienceearlysignsofatrend
towards increased consumer confidence in online payments
can be seen. Another notable development with the gain in
maturityofe-commerceistheincreasingfocusofsellerson
providingproductssuitabletothisparticularsaleschannel.In
particular,theamountofdigitallyavailableservicesandcon-
tent on the Internet has grown exponentially over recent
years[OECD(2004a)].
Butforthesepositivetrendstofinallyleadtothelong-expect-
edgrowth inmarketsharetherewillbeaneedfortheexis-
tence of well-developed online payment solutions that are
adjusted to the precise payment transaction demands of
e-commerce.Afirstoverviewofthisfinancialtransfermarket
showsa largevarietyofsystems, ranging fromcreditcards,
electroniccurrency,andmobilesystemstopaymentsolutions
viaonlinebanking.However,whenanalyzingactualusagethe
numberoffeasiblepaymentplatforms,particularlyforinter-
nationaltransactions,decreasestojustafew,withaclearlead
forcreditcards.Thus,withthedominanceofcreditcardsand
thesuccessofbutafewalternatives,thequestionarisesasto
whether the online payment market is prepared to serve
e-commerce. In particular, this would demand an ability to
allow secure international payments, to conduct person-to-
person transfers, as well as payments of different amounts
including micro-payments. This article aims to brush some
broadconclusionsonthisquestion.
The dominance of credit cards for online pay-ments Themarkethasbeenfromthestartdominatedbytraditional
financialintermediariesofferingconventionalelectronicpay-
mentservicesaugmentedwithminorinnovationstoadaptto
the Internet. In 2003, 94.1 percent of all worldwide e-com-
mercetransactionswereconductedusingcreditcards[Pago
(2003)]. Furthermore, the current trend suggests that their
importance will remain at least as significant in the near
future.Forexample,fortheyear2003,VisaEuroperegistered
adoublingofrevenues,ascomparedtothe2002results[Visa
(2004)],fromInternetsalesto12.6billion.
AdetailedsurveyofE.U.e-commercewebsites2showsasimi-
larpicture,thatfortheseeconomiesclassiccreditcardsare
alsothemostfrequentlyproposedpaymentsystems,with71
percent.Butthesurveyalsoshowsthatothersystemsareof
importance,notablydirectdebitcards,offeredby45percent
Figure1:Paymentmethodsmostfrequentlyproposedbye-commercewebsites
Source:PwC[2003]
Figure2:FactorsdiscouragingU.S.consumersfromusingcreditcardsonline
Denm
ark
Finlan
d
Germ
any
Austria
Spain
TheNet
herlan
ds
Portugal
Belgiu
mIta
ly
Greec
e
Fran
ce
Luxem
burg
Irelan
d
UnitedK
ingdom
100
90
80
70
60
50
40
30
20
10
0
Creditcardpayment Directdebit E-banking
Factor Percentage
Concernaboutsecurity 70%
Difficultiestoenterinformation 9%
Donothaveacreditcard 7%
Donotlikeinterestcharges 6%
Purchasevaluetoosmall 4%
Exceededpersonallimit 4%
Source:PaymentOne,April2003
3 ForadetaileddiscussiononsecurityofonlinepaymentsseePwC(2003).
4 ForfurtherdetailsseeVisa,2001a,bandMasterCard,2003
online payments systems for e-commerce
Additionally,theestablishedtrustinbanksinsomecountries
may also allow greater confidence of consumers, as is the
caseforcreditcards[Kallioetal.(2003)].However,toorga-
nizethissystemonanationallevelseemstostronglydepend
uponbankingindustryco-ordinationandagreements.Given
themainlynationalorganizationoftheretailbankingsector,
thedevelopmentofinternationalpaymentsislikelytobedif-
ficultandinitiallycostly.Alsoformicro-payments,itdoesnot
ofitselfprovideanidealsolution.
Payment means with only limited success — Electronic cashElectronic currency systems, whether in the form of smart
cardsoronlinecashsystems,aretheelectronicequivalentto
cash.Thispotentiallymakesthemparticularlyimportantfrom
thepointofviewofmicro-paymentsandanonymity.However,
theirintroductionhaslargelyfailedandmostoftheexisting
paymentmeansofthiskindarenotwidelyused.Theirpoten-
tialadvantageshavenotbeenenoughtooutweighanumber
of difficulties, such as the question of liability, the cost and
way of distribution, and most importantly the difficulty of
building up a wide network. Furthermore, through ‘virtual’
credit card numbers offered free of charge, such as those
offeredbyCitibank, credit cards seem toprovideapossible
methodforconsumerstosolvetheproblem.Unlesscombined
withothernetworks,itdoesnotseemthatelectroniccurrency
systemscangainsignificantmarketshareinthenearfuture
asthenetworkconstraintsseemtobestrong.
successful alternative payment systems — mediating services and payments via online bank-ingThemediatingservice,PayPal,hasdemonstratedthat,under
favorable conditions, new payment systems can succeed
despitethedisadvantageofaninitialsmalluserbase.These
systems introduceanadditional intermediary layerbetween
sellerandbuyersothatpaymenttakesplaceviathemediat-
ingserviceprovider.TobeabletousePayPal,thenewcomer
has to create an account with the service, which can be
chargedusing, for instance,creditcards. Inordertopayvia
PayPal the seller only needs to indicate the seller’s email
addressandtheamounttopay.Thesellerwillreceivethepay-
mentonhisorherPayPalaccountandwill not receiveany
furtherfinancialinformationaboutthebuyer.
PayPal’ssuccesslargelycameaboutthroughitspopularityon
Internet auction sites, given that the service permitted per-
son-to-personpayments.SinceitspurchasebyeBayin2002,
itsaspirationstotransformitshighlysuccessfulU.S.business
into a worldwide one have been given a further boost.
Currently,one in threeonlineshoppers in theUnitedStates
has an account with the company, a number which corre-
sponds to one-quarter of Citigroup’s clients [The Economist
(2004)]. Although mostly prominent in online auctions, the
gained popularity of the service particularly in the United
Stateshasledtoitsavailabilityforarangeofotherpayments,
such as tax transactions. The company is also seeking to
adjustpricestocompeteforashareinthegrowingmarketfor
micro-payments[Navaine(2003)].
mobile payments: A promise still to be fulfilled Mobilepaymentscanrefertoavarietyofpaymentsystems.
Foronething,themobiledevicemaybeuseddirectlyforpay-
ment, such as transactions where the telephone bill is
charged.Also,itmaybeusedasadevicetopay,forinstance,
viathebankaccount.AnexampleofthelatteristhePaybox
system,whichiscurrentlyoperatinginAustria.Inthismecha-
nismthemobilephone isusedasasecuredevicetopermit
payment.Thecliententersthemobilenumbertogetherwith
theamounttobepaid.Confirmationtakesplaceviaentering
a personal Paybox PIN. An automatic reply from Paybox
acknowledgesthepayment.Theamountwillbedebitedfrom
thecustomer’sbankaccount.
The potential significant advantage of mobile payments is
that they may provide greater applicability than other pay-
mentmeansbecauseoftheveryhighusageandavailabilityof
mobiletelephones.Mobiledevicesmaythusbedevelopedas
paymentmeansforbusticketstoofflineandonlinepurchas-
es. Accepting mobile payments may become attractive for
54 - The Journal of financial transformation 5 Ina2002surveyofretailers,conductedbyGartnerConsulting,44percentof
retailersclaimedtheyhadnewgoodsandservicestosellifanewmicro-payment
systemexisted[Maguire(2004)].
online payments systems for e-commerce
Responding to this problem, credit card companies have
developedaseriesofmeasuresthateffectivelyremovesecu-
rity risks.An importantproductdevelopment tomention is
Verified by Visa. This is a system which connects the card
owner for each transaction directly with the personal bank
through password authentication and a personal message
verifyingthebankconnection.Anotherimportantstep,which
recognizesthatsecuritymeasuresappliedbymerchantsare
crucial, has been the move to impose obligatory security
standards for merchants4. It remains to be seen whether
these developments will also lead to increased consumer
confidenceorwhetherfurtherinitiativesarenecessary.
Protecting anonymityAnadditionalissuerelatedtoaccount-basedpaymentsgener-
allyisthelackofanonymity.Asopposedtotransfersinvolving
papercurrency,thisformofpaymentallowsforthepossibility
totraceconsumerpurchases,anissuewhichraisessubstan-
tialquestionsonprivacyprotection.Thecurrentabsenceof
onlineequivalents tocashpaymentsmeans thatconsumers
leavemore ‘traces’onpurchasinghabits intheonlineworld
thanintheofflineone.
new payment challenges: micro-payments and auctionsIt should be noted that credit cards are not suitable for all
paymenttransfersrequiredfore-commerce.Forexample,in
onlineauctionsandothermarketsrequiringmicro-payments
—meaninginparticulartransfersofsmallmoneysumseven
oflessthanU.S.$1—creditcardsarenotreallythemostsuit-
able modes of payment. Auction markets, and especially
providereBay,havegainedhighpopularityon the Internet,
mainlybecausetheymakeitpossibleforprivatebuyersand
sellersandsmallmerchants toalsoaccess largeaudiences.
However,thecharacteristicsofauctionsrequiretheabilityto
realizeperson-to-personpayments.Sellerswantingtoaccept
creditcardpaymentsneedtohaveamerchantaccountwith
credit card companies. The costs involved would not make
onlineauctionsalesworthwhileforarangeofsmallsellers.
Furthermore,thedesignofcreditcardpaymentsisnotsuitable
fortransferringsmallquantitiesofmoney.Micro-paymentsare
ofgrowingsignificancefore-commerce5,particularlybecause
theyareakeyconditioninthedigitalcontentmarketwherea
rangeitemshavelowunitcosts.Thepossibilityofonlinerather
thanphysicaldeliveryof items,suchasmusictracksordigi-
tized articles, make the electronic sales channel particularly
attractive. Using credit card payments to realize these small
paymentswouldrenderthesetransactionscostly.Asaresult,
muchof themarket formicro-paymentsdoesnotexistor is
confined to subscription type payments. However, as Steve
Jobs,CEOofAppleComputer,statedinApril2004:‘Thesub-
scriptionservicesarenotsucceeding.Peoplewanttoowntheir
music,notrentit’[Chaffin(2004)].
The contribution of debit cards and online bank-ingIn countries such as Germany, Sweden, and Denmark and
manyotherEuropeancountriesdebitcardsprovideanimpor-
tantpaymentchannelforonlinepayments.Oneadvantageis
theirwideruserspreadparticularlyamonglow-endcustom-
ers who may not fulfill conditions to obtain credit cards as
well as institutional arrangements on credit transactions.
Agreements with credit card institutions often also allow
usageofdebitcardsfor internationaltransactions.Because
thepersonalaccount isdirectlydebitedsomecostssavings
overcreditcardsmayarise.However, thebasicstructure is
thesame.Consequently,debitcardsdonotprovidesolutions
to correct the shortcomings of credit cards, such as in the
area of micro-payments. Additionally, debit card payments
may benefit from weaker legislative protections [OECD
(2002)].Topayviaonlinebankingisawidelyusedalternative
payment option in Finland, Portugal, and the Netherlands.
Among the various payment systems, the most interesting
optionistheonewherethee-commerceselleroffersapay-
mentoptionwherethebuyerisredirectedtohisorherbank’s
website.Thepaymentisthendoneusingtheonlinebanking
facilitiesprovidedby thebank.Particularadvantageof this
system is that existing facilities and security arrangements
installed by banks to permit online banking are used.
556 AnimportantstephasbeentakenwiththecreationofSimpay,anewmobilepay-
mentservicesassociation,whichwasfoundedinFebruary2003byOrange,
TelefonicaMoviles,T-Mobile,andVodafone.Itsaimistocreateanetworkallowing
forinternationalmobilepayments.
7 Paysafecardisaprepaidpaymentservicethatcanbeusedformicro-paymentson
theInternet.Thecardsareofdifferentvaluesbetween25and100andcontain
a16-digitnumber(PIN).
8 Payexisanelectronicwalletforonlineandmobilecommerce.
9 Germanyhastwosuchsystems:FIRSTGATEclick&buyandMicromoney.
10 InDenmark,PBSisaserviceproviderforthreesystems,whichoperatemicro-pay-
ments,Valus,EWire,andCoinClick.Internetmerchantswantingtoacceptoneof
themicro-paymentsolutionshavetomakeanagreementwithoneofoperators.A
customerwantingtomakeuseofmicro-paymentspaysarelativelysmallamount
inadvancetotheoperatorusingordinarypaymentsolutionslikedebitorcredit
cards.
online payments systems for e-commerce
merchants because of the wide spread of mobile phones.
Wireless access has, as recently stressed by the OECD
(2004c),shownthemostimpressivegrowthintelecommuni-
cation infrastructure.Youngpeople, inparticular,whichcon-
stitute an important part of digital content demand (for
instance,ringtonesandgames)maynothavecreditcards,so
paymentviamobilephonebills(orphonecards)maybethe
onlywayforthemtopurchasegoods.Furthermore,itcouldbe
devised so as to allow payments from any mobile phone.
Mobilepaymentsmayparticularlybeusefultopermitdown-
loadingandprovidingmobilecontent,anareaofpotentially
strongestinitialimpact.
Asforpresentusageofmobilepayments,intheareaofdigital
content related to mobile phones, such as downloadable
gamesandringtones,premiumSMSisoftenandfrequently
used[OECD(2004d)].However,atpresentfewconsumersuse
theirmobilephoneasapaymentdevice.Forinstance,survey
results for Finland find that less than 7 per cent of mobile
phoneusersusedtheirphonetopurchaseororder in2003
(Statistics Finland, Survey Results of Autumn 2003). Also,
Paybox,theproviderofthemostelaboratedmobilepayment
system, had to discontinue its operations in Germany, the
UnitedKingdom,andSwedenearly2003,mainlybecauseof
the existing limitations to realize mobile payments.
Furthermore,developingmobilepaymentsasameanstoper-
mitinternationalpaymentssuitablealsoformicro-payments
requiresstepstoensureinteroperability6.
solutions for micro-paymentsMobile payments have already revealed their usefulness for
micro-payments. An example of micro-payments from tele-
phonyistheCoinletsystemdevelopedbyPortalify(Finland),
which provides for premium-rate SMS and premium-rate
voice.Theproblemwiththesepaymentsisthattheyarenot
widelyofferedasyetandthatfrequentlyareonlyavailableon
a national basis. An additional way in which telephony may
eventuallybesuccessfulwouldbeasanalternativewaytoadd
the cost of the transaction to existing monthly bills (most
importantlytelephonebills.)TheGermanClick&Paynet900
micro-billing solution offers the possibility for consumers to
payviatheirtelephoneconnection.
There are also prepaid systems providing possibilities for
micro-paymentsontheInternet(e.g.Paysafecard7andMicro-
moneyinGermany).Thecardisnotreloadableandcontains
nootherinformationthana16-digitnumber(PIN),concealed
under scratch foil. Other countries, such as New Zealand8,
havealsodevelopedthesekindsofinstruments.However,to
the present none of these payment mechanisms have been
widelyofferedbyproviders.
Anotherpotentialsolutiontotheproblemofmicro-payments
hasbeenthedevelopmentofcumulativecollectionservices.
Rather than paying for each individual transaction, overall
expenditure is summed once a month for payment through
the payment infrastructure. It may be offered by a micro-
paymentorganizationconnectingtoavarietyofmerchants.
Examples are Cartio Micro-payments and Clickshare. Such
paymentmechanismshavealsobeenintroducedforinstance
inGermany9andDenmark10.
Growthinthemicro-paymentoptionsviamobilephoneshas
beenpredicted,with‘direct-to-bill’expectedtobeparticularly
important[TowerGroup(2004)].AsforInternet-basedsolu-
tions, the aggregation-based solutions are expected to take
the lead with prepaid systems being the alternative option.
However, given the current weakness of prepaid solutions
(apart from mobile prepaid payments), it is questionable
whether prepaid Internet systems will become a powerful
means for micro-payments. The future seems to lie rather
with cumulative account systems and mobile solutions. This
beingsaid, theactualestablishmentofa leadingsolutionto
micro-paymentsenjoyingwideadoptionisstilltoarrive.
conclusionsThereareanumberofpaymentsystemsforonlinepurchase
thathavebeenproposedandarecurrentlyavailable.Atpres-
entcreditcardsarebyfarthemostpopular,withelectronic
currency systems not an efficiently available option. As for
other payment means, PayPal seems to have been able to
56
Emerging models
six smart moves when playing the smart card game
leo Van HoveAssistant Professor of Economics,
Vrije universiteit Brussel (Free university of Brussels)
Abstract
We are witnessing a shake-out in the European electronic
pursemarket.Severalcardsthathavebeeninthemarketfor
yearshaveorareabouttodisappear.Ontheotherhand,there
areanumberofschemesthataredoingreasonablywell,par-
ticularlyintheBenelux.Thisarticlelooksatthemixedexperi-
encewithe-pursesinEuropefromapragmaticpointofview
andtriestohighlightthemistakesthatweremadebythelos-
ersandthesmartmovesthathelpedthewinners.Thearticle
triestosummarizethe lessons learned insix 'smartmoves'.
Theselessonsshouldbeofinteresttonewere-purseschemes
elsewhereintheworld,butalsotoothernovelpaymentsolu-
tionsthattargetthemarketforlow-valuepayments.
57
six smart moves when playing the smart card game
merchantswillbereluctanttoinvestinterminalsunlesssuf-
ficient consumers have shown an interest, while consumers
willnotusethenewmeansofpaymentunlessthereissuffi-
cientmerchantacceptance.
In order to break this vicious circle, therefore, backers of a
new payment instrument have to succeed, in one way or
another,inensuringthattheinstalledbaseofbothmerchants
andcardholdersexceedsthecriticalmasspoint. Intheearly
stages of the product lifecycle, e-purse operators should,
therefore, focusonbuildingthe installedbase.Attractingas
manyearlyadoptersaspossible,onbothsidesofthemarket,
isofcrucialimportancetogetthebandwagonrolling.Indeed,
oncetheadoptionratehassurpassedthecriticalmasspoint,
the success of an e-purse can become self-reinforcing: the
moreconsumersusethecard,themoremerchantswillaccept
it,themoreinterestingitsusewillbecomeforasyetuncon-
vincedconsumers,andsoon.
Lookingback,mostEuropeane-pursesponsorshavetriedto
solvetheconundrumbyfocusingtheireffortsonconsumers
andhopingthatmerchantswouldfollow.Obviously,afastand
massive deployment of cards can be instrumental. It is no
coincidence that some of the more successful European
schemeshavesucceededinputtinge-pursesintothehands
of cardholders very quickly. This is true for miniCASH in
Luxembourg, Quick in Austria, and Chipknip in the Nether-
lands [Van Hove (2004)]. Rather than issuing stand-alone
e-pursecards,issuersinthesecountriessimplyincorporated
theire-pursesintotheexistingdebitcards,andsubsequently
tookadvantageofabigwaveindebitcardrenewal.
However,sucha ‘big-bang’strategy isnoguaranteeforsuc-
cess. In several countries where issuers flooded the market
withunsolicitedcards,manyhaveremainedunused.Germany
isasalientexample.Attheendof2002,somesixyearsafter
itsnationwide launch, thepenetrationrateof theGeldKarte
hoveredaround80%of the totalpopulationbut reportedly
only2%to3%ofcardholderswereactivepurseusers.Partof
theexplanationisclearlythatthebackersofGeldKartewere
not very successful on the acquiring side, the number of
GeldKarteterminalsremainedverylow[VanHove(2004)].
Withhindsight,amassiveroll-outofcardsonlyseemsadvis-
ableinverysmallcountries,wherethemuch-neededconcur-
rent promotional efforts on the merchant side can also be
conductednation-widepreciselybecauseofthe limitedgeo-
graphicalscale5.Luxembourgisacaseinpointhere.Inaddi-
tion,chancesarethatinasmallcountrythenumberofactors,
both issuers of cards and organizations on the acceptance
side,islower,thusreducingcoordinationproblems.Forexam-
ple,itmaybesufficienttoconvinceoneortwooperatorsand/
orauthoritiesinordertoattainadequatecoveragein,say,the
parkingbusiness.Theenvironmentmightalsobemorehomo-
geneous in terms of the technology used in, say, vending
machines.
In this respect it is interesting to underline that although
Belgium is a relatively small country, the Proton card was
neverthelessintroducedinphases,citybycity.IttookBanksys
morethantwoyearstocoverthewholeofthecountry.The
FrenchMoneocard—whichwas launchedseveralyear later
than the firstwaveofEuropeane-purses, thusproviding its
sponsors with an opportunity to learn from the mistakes of
others—wasalsolaunchedprogressivelyrightfromthestart,
withbanksacquiringlocalmerchantsaswellasinstallingload-
ingterminalsbeforelaunchingtheservicewithconsumersin
aparticularregionorcity.
Othere-purseoperatorshaveturnedtogeographicfocusing
aftersometime.EuropaySwitzerlandreconsidereditsstrate-
gyinyear5.Ratherthancontinuetotargetthewholeofthe
territory, in 2001 the ‘Zenterstrategie’ was introduced, as is
evidentfromtheAnnualReportforthatyear:‘Anewconcept
is geographic focusing: efforts will now be concentrated on
so-called ‘Acenters’—orcities,whichhaveconvertedpublic
transportation to CASH’6. In the same year, the marketing
campaignofZKAinGermanyalsostartedtargetingcities.In
2003, Munich was chosen as the ‘GeldKarte-Vorreiterstadt’
(GeldKarte pioneer city). According to Jan Hendrikx, Euro
58 - The Journal of financial transformation 1 Adams,J.,2004,“LeveragingtheEMVplatform,”EuropeanCardReview,11:1,p.20
2 TelekursGroup,AnnualReport2003,p.14
3 Source:EuropeanCentralBank,Euro-denominatedelectronicmoneyincirculation
intheeuroarea,September2004
4 “25jaarelektronischbetalen:tijdvooreenbalans,”Revuebancaireetfinancière/
Bank-enFinanciewezen,Nr.2004/6,September2004,p.302
six smart moves when playing the smart card game
595 Asanaside,thisalsohelpsexplainwhycitypilotsinvariablyprovetobemoresuc-
cessfulthannationwideroll-outs.
6 Telekurs,AnnualReport2001,p.18.
The second half of the 1990s saw a flood of so-called elec-
tronicpurses—chipcardsthatcanstoremultipurposeprepaid
value — being launched on a nationwide scale, especially in
Europe.Currently,however,wearewitnessingashake-outon
theEuropeane-pursescene.Severale-pursesthathavebeen
inthemarketforyearshaveeitherdisappearedorareabout
todoso.InJanuary2004,theSwedishbanksannouncedthat
they will close down their Cash scheme by autumn. Four
months later, Danish EFT operator, PBS, made a similar
announcement. The Danmønt card, which was launched in
March1993andisgenerallyseenasthefirstreale-purse,will
be discontinued from 31 December 2005. Earlier, the
PortugueseMultibancopurse—anotherpioneer—hadalready
defactodisappeared:in2002onlyafewthousandactivated
cards remained in circulation. Visitors to the Sociedade
InterbancáriadeServiços(SIBS)website,theoperatorbehind
thePortaMoedasMultibanco,willlookinvainforevenaminor
referencetoaconceptthatoncereceivedtremendousmedia
attention.
Thesurvivalofotherpurses isalso inquestion.Finland, for
example,islikelytoreplaceitsAvante-pursewithofflineuse
ofastandardEMVdebitcard,accordingtoEeroVasenius,Vice
President of Nordea Bank Finland, on the basis that ‘elec-
tronic purse does not fly in Europe’1. The following quote
taken from the 2003 annual report of the Swiss Telekurs
Groupisalsonotveryencouraging:‘Sincethepastyear,the
valuecardCASHhasonlybeenmanagedasanicheproduct
andisnolongerbeingsupportedintermsofadvertisingwith
largecampaigns.Thenumberoftransactionsconductedwith
CASHdecreasedinthereportingyearby5.4percent,to19.4
million’2.
Ontheotherhand,thereareanumberofEuropeane-purse
schemesthataredoingreasonablywell,thanksinparttothe
introductionoftheeuro.Theaggregatedstatisticsmaintained
bytheECBshowthattherewasajumpinthevalueofhard-
ware-basedelectronicmoney incirculation in theeuroarea
from 170 million in November 2001 to 208 million in
December2001,on theeveof the introductionof theeuro,
andto240millioninJanuary2002.Theoverallamountof
e-moneyincirculationhascontinuedtoincreaseafterwards,
albeitonlygradually:thefigureforAugust2004is283mil-
lion3.ParticularlyintheBeneluxcountriesusageofthelocal
e-purses — called Proton, Chipknip, and miniCASH, respec-
tively—jumpedsignificantlyfollowingthelaunchofthecom-
moncurrency[VanHove(2004)].InBelgium,partoftheeuro
impact has since evaporated, especially when measured in
termsofactiveusers,andinarecentinterviewBanksysCEO,
Dirk Syx, called Proton a ‘commercial disappointment’ as
transactionvolumesremainsignificantlybelowtarget4.Still,
BanksysisnotgivinguponProtonandwillshortlybelaunch-
inganautomaticreloadfunction.
So,clearly,thefortunesofEuropeane-purseshavebeenvery
mixed.Thisarticle looksat theEuropeanexperiencefroma
pragmaticpointofviewtofindoutwhatcanbelearnedfrom
thesedisparatefatesandtoidentifycharacteristicsthatcan
help us distinguish between winners and losers. The article
putsforwardsixessential ‘smartmoves’,whichshouldbeof
interesttorelativenewcomersonthee-pursesceneoutside
Europe,suchasDexitinCanadaandEdyinJapan,aswellas
providersofmorenovelsolutions,suchasmobilepayments,
thattosomeextenttargetthemarkets,suchaslow-valuepay-
ments,whiche-purseshavefailedtocapture.
smart move number 1: mind the network externalitiesPerhapsthemostimportantproblemoperatorsarefacedwith
when launchinganelectronicpurse istheso-calledchicken-
and-egg deadlock. This is because e-purses are subject to
network externalities; put simply, the utility of the payment
instrument increaseswith thesizeof thenetwork.Stronger
still,ane-purseonlybecomessufficientlyusefulifthesizeof
the network exceeds a certain minimum level, the so-called
criticalmass.Thisistrueforconsumersandmerchantsalike,
althoughtherelevantnetworkdiffers.Whatmattersforcard-
holdersisthenumberofterminalsandwhatisimportantfor
merchantsisthenumberofactivecardholders.Insuchatwo-
sidedmarketthereclearlyisacrucialcoordinationproblem:
7 ECR,2003,“Electronicpurse:LastchanceforGeldKarte”EuropeanCardReview,
10:2,p.5
8 EUROKartensysteme,AkzeptanzderGeldKarteinMünchensteigtdeutlich-
Vorreiterstadt-Kampagneerfolgreich,pressrelease,September4,2003.
9 “Japan’scontactlesscashgoesnationwide,”Itworld.com,July19,2002;emphasis
added.
10 Dexitenablesconsumerstopayforlow-costitemswiththetapofaRFID(radio
frequencyidentification)taglinkedtoapre-paidaccount.TheRFIDtagscomein
theformofkeyfobsoradhesivestickersthatcanbeattachedtocellphonesor
otherdevices.
11 Dexit,InvestorRelations,webpagehttp://investors.dexit.com/overview.
asp?ticker=t.dxt,visitedonAugust12,2004.
six smart moves when playing the smart card game
trieswherethisseemstohavehappenedwithoutproblems.In
atradepublication,FransBaeyens,generalmanager,domestic
paymentsanddepositsatKBCBankinBelgiumwasquotedas
saying: ‘2002wasthe firstyear thebanksmadeaprofiton
thisactivity.Itrequiredanenormouseffort,butalltheparties
involved kept the faith in the business case for years on
end’12.Ihavealsonotcomeacrossanyevidenceofmajorrifts
betweenbanks inAustriaandFrance, although in the latter
casethenationallaunchofMoneomayhavebeendelayedby
thesearchforacommonsolution.
In Germany, on the other hand, not all banks have been
equally active in promoting the GeldKarte. The cooperative
banks,representedbyBVR,haveaddedthee-pursetoalmost
alltheireccards.TheSparkassen-Finanzgruppe,thegroupof
more than500savingsbanks,hasalsobeenanactivepro-
moter. The private banks, for their part, have been far less
active.TheHypovereinsbank,thesecondlargestprivatebank
inGermany(withsome8.5millionclients),hasneveroffered
the GeldKarte. Dresdner Bank decided to stop issuing the
GeldKarteinJune2002becauseofweakdemand.Unlikethe
savings banks, Dresdner Bank did not automatically include
the e-purse function on its debit cards. Finally, while the
DeutscheBank24(with7.4millionclients)continuestoback
theGeldKarte,sincethestartof2002theyonlyofferitasa
separate card. The result is that, as a survey by InterCard
shows,whileonanationalscalechippenetration(asa%of
the number of ec cards issued) averages 68%, in some
regionsthisfigureisbelow26%—dependingonwhichtypeof
bankshaveahighmarketshareinthoseregions.Thisispar-
ticularly true for former Eastern Germany13. With lesson
number1,ontheimportanceof(local)criticalmass,inmind,
thisisclearlynotbeneficialfortheuptakeofe-purses.
In other countries too, some of the issuers have done little
morethanpayinglipservicetothecommone-purseproject14.
Summing up, the third major lesson appears to be that the
e-pursemarketisactuallyathree-sidedmarket,inthesense
thatane-purseoperatornotonlyhastoconvinceconsumers
andmerchants,butalsoneedstomobilizeissuers.
smart move number 4: Know your foesBefore launching an e-purse it is important to have an idea
aboutwhichpaymentinstrumentswillbeitsdirectcompetitors
andhowtheyarepriced.Thiscandiffersubstantiallyacross
countries. One reason for the lack of success of e-purses in
Nordiccountriesappearstobethatdebitcardscanbeusedfor
lower-valuepayments,unlikemanyothercountries.Jyrkönen
and Paunonen (2003) of the Bank of Finland, for example,
point out that ‘the use of e-money is at a very low level in
Finland. One reason for this is that Finnish consumers are
accustomed to paying with other payment cards, especially
w i t h d e b i t
cards,thatcanalsobeusedforsmallpayments.’Inthisrespect
it is interesting to note that, unlike in Belgium for example,
Finnish debit cards are mainly off-line. Similar explanations
appeartoholdforSweden,Denmark,and Iceland[VanHove
(2004)].Thisobviouslyreducesthemarketfore-purses.
WhereDenmarkisconcerned,averyspecificcircumstanceis
thatdebitcardsare freeofcharge forconsumersandmer-
chantsalike.Asaresult,accordingtoHenrikArntAndersenof
DanmarksNationalbank,‘debitcardsareusedforvirtuallyall
transactions,’ even transactions of1 or2. It is also obvi-
ously important to know how the ‘natural enemy’ of any
e-purse,goodoldcash,ispriced.Inmanycountries,thepublic
hasbeensparedtherealcostofcashusage.Thatis,thedirect
chargesfacedbyconsumerswhenusingcurrency, ifany,do
notcoveritsfullcost.Hence,consumersmistakenlythinkof
currencyasbeingfree.Thisobviouslymakesitmoredifficult
fore-purses,andotherelectronicpaymentsystems, togain
ground.Inothercountries,however,thenumberoffeecharg-
ingATMsisontherise,withtheU.K.beingoneexample.All
other things being equal, in such an environment e-purses
shouldstandabetterchanceofbecomingsuccessful15.Dexit,
forexample,appearstobeinsuchapositionbecauseCanadian
consumersareaccustomedtopayingforATMwithdrawals.
smart move number 5: Know your marketWhensettingoutlessonnumber1,itwasalreadypointedout
thatmanye-purseoperatorshavepiggybackedontheexist-
60
six smart moves when playing the smart card game
KartensystemeCEO,suchactionsaresuccessful;‘we’vefound
thatwithapush,usagejumps40%-60%andstaysthere’7.In
Munich,GeldKarte transactionseven jumpedby 116% in the
firsthalfof20038.
Interestingly,e-purseschemeselsewhereintheworldalready
seemtohaverealizedtheimportanceofgeographicfocusing.
ThisishowanInternetsourcedescribesthestrategyfollowed
byJapaneseoperatorBitWalletinpromotingitsEdypurse:‘In
addition to going after large retail chains, BitWallet is also
looking to court independent retailers in single locations to
createsomethinglikeEdyhotspotswherealargenumberof
retailers accept the card’9. There are also indications that
Canadian payments firm Dexit Inc., the newest kid on the
e-purse block, is taking that lesson to heart. Established in
October2001,Dexitlauncheditspay-with-a-waveservice10in
September 2003 in downtown Toronto. So far Dexit debit
express is only available in the Greater Toronto Area, but
Dexit's‘objectiveistoexpanditsserviceinkeystrategicareas
acrossCanada,startinginthefallof2004’11.
smart move number 2: mind the network externalitiesThesecondlessoniscloselyrelatedtothefirst:inviewofthe
all-importantnetworkexternalities,theintroductionofseveral
incompatiblee-purseschemesatmoreorlessthesametime
may well prove detrimental for all of them. This is because
incompatibility creates uncertainty among consumers and
merchants,andcutsupthemarket,thusmakingitevenharder
toattaincriticalmass.Forexample,considertheintensecom-
petitionbetweenChipknipandChipperintheNetherlands,or
the fragmentede-pursemarket inSpain,whereno less than
three incompatible schemes (Monedero 4B, Visa Cash, and
Euro 6000) were launched in a matter of eight months.
Tellingly,eventodaySpainhasminimale-purseusage.
Inhisrecentdoctoraldissertation,GottfriedLeibbrandtnotes
that‘therearesomeinterestingexamplesoffirmsthathave
tried to compete on standards in payments, but ultimately
joinedtheindustrynetwork’[Leibbrandt(2004)].Oneofthe
exampleshereferstoispreciselythebattlebetweenChipknip
and Chipper in the Netherlands, where eventually only the
Chipknipschemesurvived.InApril1999,threeyearsintothe
‘standardswar’,thetwoschemessignedanagreementoutlin-
ingacommitment toensure interoperability. InMarch2001,
Postbank and ING Bank decided to abandon their Chipper
technology altogether, phase out the Chipper brand, and
migrate to Chipknip by early 2002. This is exactly what the
theoreticalmodelspresentedbyLeibbrandtpredict.Thestart-
ingpointofhisanalysisisthatpaymentinstrumentsaresub-
jecttonetworkexternalities,asthisarticlehasbeenpositing
allalong.Inhismodels,Leibbrandtalsoanalyzedtheadoption
ofthese,andother,networktechnologiesbyexistingfirmsin
anindustry,suchasbanks,aswellasthecompatibilitydeci-
sions that these firms face. He shows that when there is
‘autarky’ — meaning that transactions take place dispropor-
tionallywithincountries,asisclearlythecasewithe-purses,
—‘thetechnologylandscapecanwellbeheterogeneousacross
countries,[but]itwillbehomogenouswithincountries’.
Giventhat,firstly,onlyonetechnologyislikelytosurviveand
secondly,astandardswarisharmfulforallplayers,thelogical
adviceistopreventsuchawarinthefirstplace.InFranceand
Switzerland,itinitiallyalsolookedlikeseveralschemeswere
goingtocompetehead-to-head,butluckilyinthesecountries
allplayersagreeduponacommonsolutionbeforeanyofthe
schemes were launched on a national scale [Van Hove
(2004)].Interestingly,inFinlandthefirstversionoftheAvant
e-pursewaslaunchedbyasubsidiaryofthecentralbank.By
takinganactivepartinthedevelopmentofthenewpayment
instrument,theBankofFinlandpreciselywished‘toavoidthe
unnecessary emergence of several parallel or overlapping
cardsystemsinFinland’[KokkolaandPauli(1994)].
smart move number 3: Know your friendsBuildingonthepreviouslesson,itisonethingtoagreeona
commonstandard,butforane-pursetobecomesuccessfulall
participating issuers and acquirers must also be completely
committed. This is not evident, as it implies cooperation
betweencompetitors.BelgiumandLuxembourgaretwocoun-
6112 ECR,2003,“Electronicpurse:LastchanceforGeldKarte”EuropeanCardReview,
10:2,p.5
13 InterCard,Chip-Ausstattungderec-Bankkartenfälltaufunter70%,pressrelease,
April2,2003.
14 ExamplesarethePostOfficeinSwitzerlandandSvenskaHandelsbankenandS-E
BankeninSweden[VanHove(2004)].
15 Althoughtherearecurrentlynoe-purseschemesactiveintheU.K.
16 Acaveathereisthatadistinctionhastobemadebetweenthenumberoftrips
registeredandthenumberofactuale-pursepaymentsmade(forsinglefares).
Also,Octopusisonlyslowlymakinginroadsintheretailenvironment.
six smart moves when playing the smart card game
significant.Compared tocash,however, all theabovedisad-
vantages cancel out. At the same time, e-purses can offer
important improvements over cash. Getting this message
acrossmaybeanotherreasonwhye-purseoperatorsshould
perhapsconcentrate,at least initially,onplaceswhichprevi-
ouslyonlyacceptedcash.
conclusionSimplifying somewhat, the ultimate profile of a successful
Europeane-purseschemeseemstobeaschemethatisactive
inarelativelysmallcountryand/oronethathasoptedfora
phasedintroduction,wheredebitcardsarefairlypopularbut
functioninon-linemodeand/orcannotbeusedforlow-value
payments,whereallplayersquicklyagreeduponacommon
solutionsothattherearenoincompatibilityproblems,where
all major banks participate in the scheme and prove to be
completelycommitted,andwherethee-purseprojectreceives
support fromplayers inat leastoneandpossiblyseveralof
the following sectors: public telephones, parking meters,
vendingmachines,andpublictransport.
Asalreadyalludedtointheintroduction,Iamconvincedthat
therecipefore-pursesuccesselsewhereintheworldissimi-
lar.However,theanalysisoftheEuropeanexperiencehasalso
shownthatcountry-specificcircumstancescanmakeaworld
ofdifference.Thesinglemostimportantlessonis,therefore,
perhapsthatitisdangeroustogeneralize.
Theintroductionalsoclaimsthattheexperiencewithe-purses
holds valuable lessons for newer generations of payment
schemes.However,while I seeclearparallels, therearealso
importantdifferences. It is,forexample,nocoincidencethat
the Dutch banks announced in September of this year that
they will stop some of their current individual Internet pay-
mentsystems—suchasTootz,Way2Pay,andE-wallet—and
thattheywill joinforcestodevelopanewinternetpayment
standard17. The important question is, however, whether a
national standard will be sufficient. Turning to mobile pay-
ments,itisclearthatlessonsnumber2(avoidincompatibility),
3(makesureallGSMoperatorsareinvolved),4(whatabout
pricing?)apply,asdolessonsnumber5and6inonewayor
another. However, there is at least one possible exception:
wheremobilepayments forcontentorgoodspurchasedvia
m-commerceore-commerceareconcerned,thereisbydefini-
tionlessneedforastrategyofgeographicfocusingwhichhas
proved to be very important in the real world. In short, the
caveatis:the‘smartmoves’putforwardhereshouldbetrans-
posedinasmartway.
References• Leibbrandt,G.,2004,“Paymentinstrumentsandnetworkeffects:adoption,harmo-
nizationandsuccessionofnetworktechnologiesacrosscountries,”doctoraldisser-
tation,UniversityofMaastricht,June
• Jyrkönen,H.andH.Paunonen,2003,“Card,Internetandmobilepaymentsin
Finland,”BankofFinlandDiscussionPaperNumber8/2003,March12
• Kokkola,T.andR.Pauli,1994,“Electroniccash,”BankofFinlandBulletin,68:12,
December,9-14
• VanHove,L.,1999,“Electronicmoneyandthenetworkexternalitiestheory:lessons
forreallife,”Netnomics,1:2,137-171
• VanHove,L.,2001,“TheNewYorkCitysmartcardtrialinperspective:aresearch
note,”InternationalJournalofElectronicCommerce,5:2,Winter,119-131
• VanHove,L.,2004,“ElectronicpursesinEuroland:whydopenetrationandusage
ratesdiffer?”SUERFStudies,Nr.2004/4
• VanHove,L.,Aselectedbibliographyonelectronicpurses(andelectronicmoney),
website,1996-2004
62 - The Journal of financial transformation
six smart moves when playing the smart card game
ingdebitcardinfrastructure.Incorporatingthee-pursefunc-
tion into debit cards obviously reduces the issuing costs
involved.Itmayalsobetemptingtofollowasimilarapproach
whereterminalsareconcerned,byconvertingdebitcardter-
minals into so-called 'combi terminals,’ terminals that can
handlebothdebitcardsande-purses.Thishas,forexample,
beendoneinAustriaandintheNetherlandsinallprobability
inanattempttoreachacriticalmassofterminals.
However, one has to realize that merchants that already
acceptdebitcardsarenotreallypartofthecoremarketofan
e-purse.Asaresult,suchacceptancepointstypicallydonot
generatehightransactionvolumes.Rathere-purseoperators
should focus on those retail sectors that typically do not
acceptdebitcards,becausetheaverageticket issimplynot
highenough.Also,surveyspointoutthatconsumersseethe
added value of e-purses particularly in unattended applica-
tions,suchaspayphones,vendingmachines,parkingmeters,
and transit systems, because these are the uses for which
cashistrulyinconvenient.
Animportantlessonis,therefore,thatbesidesthequantityof
terminals, their quality matters too. More concretely, the
European experience shows that an electronic purse needs
thesupportofatleastoneandpossiblymoresectorswitha
large number of small cash payments, such as public tele-
phones, parking meters, vending machines and/or public
transport.Althoughtheimportanceofpublicpayphoneshas
been diminishing due to the phenomenal uptake of mobile
phones,thedealwithBelgacomearlyinthelifecycleofProton
was a vital one for Banksys in Belgium. In the Netherlands,
purse-only parking in three cities has been, and still is, an
important driver behind Chipknip usage. Vending machines
aretypicallyalsopopularapplications.IntheNetherlands,for
example,vendingmachinesrepresented5.3%oftheterminal
parkatend-2002,butwith18.4%theirshareinthetotalnum-
berofChipkniptransactionsovertheyear2002wassignifi-
cantly larger. As the Octopus scheme in Hong Kong has
shown16,anotherpotentialvolume-boosteranddooropener
mightbepublictransport.However,allinall,Europeane-purse
operatorshavebeenslowinbringingelectronicticketinginto
their schemes. Part of the explanation for this is that all
Europeanschemesarecontact-based,whereasthepreferred
option for transport applications is obviously a contact-less
card.
smart move number 6: Know (and educate) your customersInJuly2004,theMoney&FinanceResearchGroupandthe
CenterforWork,OrganizationalandEconomicPsychologyof
theFreeUniversityofBrusselstogethersupervisedasurvey
of1,000Belgianconsumersovertheageof15.Thesurveywas
commissionedbyBankys,thenationalEFToperatorandspon-
sorofProton.Thesurveyconfirmedonceagainthate-purse
users on average tend to be younger and better-educated.
Thesamegroupalsoprovedtobemoreopentoawiderange
of, sometimes hypothetical, payment innovations, including
mobile payments. Early in the lifecycle of a new electronic
payment instrument, when lesson number 1 plays to its full
extent, sponsors might, therefore, want to concentrate on
theseinnovatorsandearlyadopters.
Thesurveyalsounderpinnedtheneedforthorough,andcon-
tinuous,consumereducation.ComparedtoProtonusers,non-
usersconsistentlyunderratedProtonacceptance,whileover-
rating the costs involved. Also, more than 8 years after its
launch,therewerestillimportantmisconceptionsconcerning
the degree of anonymity provided by Proton, with 40.1% of
non-usersstatingthatProtondidnotprovideadequatelevels
of anonymity, as compared to 23.9% of users. Conversely,
27.4%ofProtonusersconsiderittobeveryanonymouscom-
pared to only 15.3% of non-users. In general, as was to be
expected, non-users were less convinced of the advantages
offeredbyProton.AsIhavearguedearlier,itisimportantto
ensure that e-purses are not primarily compared to debit
cards.Indeed,comparedtodebitcards,e-purseshaveobvious
disadvantages. They must be reloaded periodically, there is
theriskoflossandtheft,usersmustkeeptrackofthebalance
on their cards, and they lose the float on their money. The
advantageofnotneedingtouseaPINappearstobenotso
6317 “INGstaaktWay2pay,ABNstoptE-wallet,”2004,PlanetInternet,September17
Transition
Payments policy in the information age
creating a profitable infrastructure — The payments challenge for banks
Payments in transition: where have all the changes gone?
Electronic payments: The drive towards a competitive, customer service driven utility
simulation: A powerful research tool in payment and settlement systems
European payment systems and monetary union
Technological innovation in retail payments: Key developments and implications for banks
Payments policy in the information ageRonald J. MannBen H. & Kitty King Powell Chair in Law, Co-Director, Center for Law, Business & Economics, The university of Texas School of Law
processed and cleared in an electronic way, which justifies
ruleslikethosediscussedabove.
Rulesrelatedtoerroraresimilar.Thetypesofeventsthatare
likelytoleadtoanerror,aswellasthemechanismsfordetect-
ing, confirming, and responding to an error are likely to
dependonthetechnologythat isusedtoclearandprocess
payments.Thus,itmakessomesensethattherulefortrans-
actionsprocessedelectronically(coveredbytheEFTA)would
differ from the rule for transactions processed entirely by
paper (conventional check transactions governed by Article
4).At thesame time, thecontinuingshiftof check transac-
tions from paper to electronic processing (probably to be
acceleratedby theCheck21Act)mightundermine thatdis-
tinction.
Rulesthatdeterminewhenapaymentismadearesimilar,in
thattheyareforthemostpartmadebasedonthepracticali-
tiesofaparticularsystem.Thus,inthewire-transfersystem,
wesaythatthepaymentiscompletewhenthebeneficiary’s
bankbecomesobligatedtopaythebeneficiary.Inthecheck-
ing system, we say that the payment is not complete with
respecttoanordinarycheckuntilthecheckispaid,butthat
it occurs with respect to a cashier’s check when the payee
acceptstheinstrument.
Rules related toreversibility,however,arecompletelydiffer-
ent. Rules related to reversibility should depend on the
dynamicsoftheunderlyingtransactioninwhichthepayment
ismade.Inthesimplestcases,paymentsystemsarespecial-
izedforuseinparticularsituations.Thus,forexample,inbusi-
ness transactions, parties often choose to make payments
withlettersofcreditorwiretransfers.Thosesystemsinclude
particular rules designed for the particular transactions in
whichtheyareused,whichdeterminethetimingandcircum-
stancesinwhichpaymentscanberecoveredorstoppedonce
the process has been initiated. Because those systems are
quitespecialized,thesystem-specificrulesworkwellforthem.
Secondly,toillustratethatframeworkinapplication,itisuse-
fultothinkaboutthetwomostrapidlygrowingpaymentsys-
tems in our economy, credit and debit cards. Existing law
drawsa starkdistinction in legalprotectionsbetween those
twosystems.Theapparentbasisforthatdistinctionistheidea
that cognitive problems that afflict borrowing transactions
justify a greater level of protection for consumers that use
credit cards than for those that use debit cards. From that
perspective,theexistingrulesdivideconsumerpaymentsinto
twoclasses.Thefirstclassincludestransactionsinwhichthe
consumer makes contemporaneous payment: cash, checks,
and debit cards. Because the consumer at the time of the
transaction understands that the payment is being made
more or less immediately, the consumer is treated as ade-
quatelyassessingthewisdomofthepaymentinquestion.
Creditcards,however,arequitedifferentfromthatperspec-
tive,becausetheconsumerthatpurchaseswithacreditcard
doesnotmakeimmediatepayment.Rather,althoughthemer-
chant receives contemporaneous payment, the payment by
theconsumer isdeferred,automaticallyuntilastatement is
receivedand,at theconsumer’soption,moreor less indefi-
nitely, as permitted by the strikingly lenient repayment
optionstypicalofthemodernAmericancreditcard.
TheAnglo-Americanlegalsystemhasalongtraditionofpro-
tectingborrowersfromthefollyofimprudentborrowing.The
most famous example surely is the centuries-long effort of
Englishcourts to invalidateaseriesofcreditordevices that
hadtheeffectofgrantingmortgagecreditorsabroadrightto
takereal-estatecollateral fromborrowerswhofailedtoper-
formpreciselyastheyhadpromisedatthetimeoftheloan.
That instinct continues to have broad application today, as
courts steadily broaden the range of devices to which that
invalidatingruleextends.
Althoughitisabitmuchtosuperimposetheinsightsofmod-
ernacademicliteratureonthepolicyinstinctsofthemedieval
66 - The Journal of financial transformation
67
The point of the longer essay this paper summarizes is to
emphasizesomething that isdeeplywrongwith thecurrent
frameworkofourpaymentspolicy.Theportionofthatpolicy
reflectedintheTruthinLendingActgrantsconsumersavari-
etyofgenerousrightsincreditcardtransactions.Bycontrast,
theElectronicFundsTransferAct,whichgovernsdebitcard
transactions,isrelativelycharyinitsprotections.Today,how-
ever,withthedebitcardmarketincreasinglydominatedbythe
PIN-less debit cards marketed by Visa and MasterCard, the
distinction between the credit card and the debit card is
almostinvisibletoallbutthemostsophisticatedconsumers.
Thecauseoftheproblemiseasytosee,ofcourse:technology
has altered the landscape of private payment institutions
whileCongresshasnothadoccasiontoupdatethestatutes
that regulate those transactions. The solution, however,
seemssufficientlydifficulttowarrantdetailedconsideration.I
startatahighlevelofgenerality,analyzingthegeneralques-
tionofwhattypesofconsiderationsshouldinformasophisti-
cated payments policy. There is of course some substantial
priorthinkingonthesubject,mostobviouslytheUniformNew
PaymentsCode(UNPC)andwriterslikePeterAlceswhocriti-
cizedthatproject.Iwanttomakethreemajorpointshere.
Thefirstpointisthatpreviousanalysishasfailedtorecognize
the importanceoftheunderlyingtransactions inwhichpay-
mentsaremadetoissuesordinarilytreatedinthelegalrules
thatregulatepaymentsystems.Thebasicproblemisthatpay-
ments policy needs to attend more consciously to the con-
texts of the transactions in which payments are made.
Existinglawarticulatesrulesthatareboundedalmostentirely
by the nature of the technology with which the payment is
made.Thus,wehaveseparaterulesforwiretransfers,letters
ofcredit,checks,electronictransfers,andthelike.Thattype
ofboundarymakessenseonlyforissuesdrivenbythenature
ofthetechnology.Itmakesnosense,however,forissuesthat
shouldberesolvedbyreferencetothenatureoftheunderly-
ingtransactioninwhichthepaymentismade.
At its heart, payments law must resolve four fundamental
questions:whobearstheriskofunauthorizedpayments,what
mustbedoneaboutclaimsoferror,whenarepaymentscom-
pleted (so that they discharge the underlying liability), and
whencantheybereversed.Thefirstthreequestionsarecat-
egoricallydifferentfromthe last,becausetheyoftenshould
beresolvedbasedonthenatureoftheunderlyingtechnology.
Thus, for example, with respect to the risk of unauthorized
payments,thefundamentalquestion ishowtodesignasys-
tem that gives adequate incentive to the user to avoid and
mitigate lossesfromunauthorizedtransactions,whilegiving
adequateincentivetothesystemoperatortomakeadvances
intechnologyandsystemdesignthatcanavoidandmitigate
thoselosses.Inourlegalsystem,wehavetakentheviewfor
mosthigh-technologypaymentsthatanalmostcompleteallo-
cation of the risk of those losses to the system operator is
appropriate.
Thepremiseofthoserules(admittedlyunspoken)isthateven
a complete allocation of loss to the network operator will
leavetheconsumerasufficient incentivetoattendtothese
problems.Thatcouldbetruebecauseofthehassleofrevers-
ing unauthorized charges, because of doubts that financial
institutionswillreadilyfulfilltheirobligationsinsuchasitua-
tion,orevenbecauseofignoranceofthelegalprotectionsfor
unauthorizedtransactions.Atthesametime,therulesreflect
theimplicitpremisethatlossesintechnology-drivensystems
are most effectively reduced by technological and system-
designinitiativesthatareexclusivelywithinthecontrolofthe
system operator. Thus, we are not surprised to see major
investmentsinfraud-preventiontechnologyinthecredit-card
and debit-card sectors. Because the justifications for those
rulesrelatetothenatureofthetechnology,itisplausiblefor
federallawtoprescribesucharuleforallelectronictransfers
fromconsumeraccounts.Itislessplausibletoincludeasimi-
larruleforcreditcardtransactionsbasedontheavailabilityof
creditinthetransaction.Itwouldbemoresensible,surely,for
thatruletobejustifiedbythefactthatthetransactionsare
monthlystatement,thetaskofmonitoringexpensestoreview
compliance with a budget (or, perhaps more commonly, to
understandthefailuretocomplywithabudget) isrendered
mucheasier.
Stillanotherfactor,atleastbycomparisontothecheck,isthe
desiretoclosethetransactionrapidly.Althoughthishasnot
alwaysbeentrue,itnowplainlyisthecasethatthecheckis
theslowestofretailpaymentmechanisms.Whenagrocery-
store customer pulls out a check-book to pay for groceries,
thehurriedcustomersinthelinebehindinevitablysigh,know-
ingthattheirwaitwillbeprotractedbytheadditionaltimefor
theconsumertowritethecheckandfortheclerktodecide
whethertoacceptit.Thatisnottosay,ofcourse,thattheuse
ofcreditcardsforborrowingisnotanimportantpolicyissue.
Itistosay,however,thatitisnotsufficientlydominantinthe
decision to use a credit card to exclude other relevant con-
cerns.
Thatargumentleadsto,atleast,twopossibleresponses.The
simplest course would be to repeal the TILA protections as
outdated.Irejectthatapproach.Instead,Ibuildontheframe-
workarticulatedabovetoarguethatthoseruleshavecome
fortuitouslytoserveotherimportantpolicies,specificallythe
transaction-relatedsalespoliciesthatareimportantinissues
ofreversibility.Themostobviousoneistoredresstheimbal-
ance in enforcement capabilities between the typical mer-
chant seller and the typical consumer buyer. If the existing
rules shift the burden of instituting and pursuing litigation
fromtheconsumertothemerchant,theymightenhancethe
likelihood that disputes in retail transactions are resolved
appropriately.Ifthatistrue,thenitjustifiestheTILArules.
Theproblemwiththatjustification,atleastasanexplanation
of existing law, is that the enforcement-imbalance concern
appliestoanypaymentsystemthattheconsumeruses.The
majorpointcuttingagainstbroadapplicationof that rule is
theneedtomaintainpaymentoptionswithdifferentcharac-
teristics,sothatmerchantsandtheircustomerscanchoose
betweenpayment systems thatare finaland those thatare
not.Inthecontextofface-to-facetransactions,Iconcludethat
credit and debit cards should have similar limitations on
reversibility, leavingopenthepossibilitythatdevelopingfor-
matslikeprepaidcardsultimatelymightbeleftonthecash-
equivalent side of the line. In the Internet context, where
creditcardscurrentlydominate,Iconcludethatthesamerule
shouldapply.Tobesure,thatdoeslimittheavailabilityunder
currenttechnologyofanypaymentoptioninthatmilieuthat
is both practical and wholly final. In the end, however, the
distinctionsbetweencreditanddebitcardsdonotseemtome
sufficient,orsufficientlyclear totheuser, to justifyamajor
distinctiononthatpoint.
68 - The Journal of financial transformation
English judiciary, thatpolicy findsbroadsupport in thespe-
cific concerns of the nascent behavioral economics move-
ment.Scholarsinthatfieldoftenpointtoanoverlappingset
oftendenciesthatgenerallyleadanormalindividualtounder-
estimatethelikelihoodofnegativefutureeventsthathavenot
previously been salient in the experience of the individual’s
circleofpersonalacquaintances.Asimilar,relatedphenome-
nonleadstosystematicunderestimationofthelikelihoodthat
anegativeeventwillhappentotheestimatingindividual,even
iftheindividualaccuratelyunderstandstheoveralllikelihood
of the event. Both of those phenomena are exacerbated by
thelikelihoodthatconsumershavehigherdiscountratesfor
eventsperceivedaslikelytooccurfarinthefuturethanthey
do for events likely to occur in the immediate future. Thus,
thosescholarswouldsay, it isreasonabletoworrythatbor-
rowers entering into credit transactions do not adequately
weighthelikelyharmstothemfromthedifficultiesthatmight
come at the time that repayment is due. Also, with a little
moresubtlety,thosewhopayinadvancemightunderestimate
thelikelihoodthattheywillharmtheirstrategicrelationswith
themerchantbyagreeingtopaynowandreceivethesubject
merchandise(orservices)later.
Finally, that concernworkswell asa lens forunderstanding
TILA.TILAdoes littleornothing toregulateanythingabout
credit card transactions divorced from their credit-related
features. The bulk of its regulations appear to rest on the
concern that crafty credit card issuers will trick consumers
into using credit cards without understanding the costs of
repayment. Thus, the statute relies heavily on a variety of
disclosure rules reflecting the well-intentioned notion that
mandatory disclosures will resolve the cognitive problems
thatafflictthepotentialcreditcarduser.
Thirdly, it seems clear that the normative underpinnings of
the current rules have become outmoded in several ways.
Mostimportantly,itseemslikelythatmany,ifnotmost,credit
cardtransactionsnolongerreflectthekindsoflong-termbor-
rowing transactions that justify the cognitive concerns that
wouldjustifytheexistingpolicy.Inthemodernera,however,
thecreditaspectofthepurchasetransaction is increasingly
obscure.Formanyofus,probablymostofthelimitedsample
of people who will read this article, the credit card is used
muchmoreforconveniencethanforanypurposerelatedto
borrowing.Toputitanotherway,weoftenpullacreditcard
fromourwalletnotbecausewelackthepresentwealthtopay
thepurchasepricefortheiteminquestion,butforsomeother
reasonunrelatedtoacreditdecision.
Ifthereisanythingthatprovesthatpoint,itistheriseofthe
convenience credit card user, who charges amounts on the
cardbutpaysoffthebilleachmonth.Oncearelativelysmall
sectorofthemarket,convenienceusersnowconstituteabout
40% of the market. For those users who consciously limit
theirspendingtowhattheycanrepayoutofresourcesavail-
ablethatmonthitisalmostdeceitfultotreatthetransaction
asoneinvolvingasignificantextensionofcredit.
Rather,weusethecreditcardforalocusofcompletelydiffer-
entreasons.Themosteconomicallyrationalmightpointtoa
desiretogetthefloat, theuseofthefundsduringthetime
thatelapsesbetweenthedateofthetransactionandthedate
thatthecreditcardbillmustbepaidtoavoidafinancecharge.
Buttherapidriseofthedebitcard,whichhasnosuchfloat,
suggests that it is not the dominating market factor in the
choiceofacreditcardovercashoracheck.
Morelikelyfactorsincludesuchthingsasadesirenottohave
tocarryenoughcashtocoverallofthepurchasetransactions
ofourdailylife.Thatisnotjustadesiretolimittheriskofa
loss fromtheft. Italsohastodowiththerelativeeasewith
which credit cards can be used, by comparison to the ease
withwhichwecangetcashfromourbanks:howmanyofus
stand at retail counters thinking something like ‘if I use a
creditcardhereitmeansIwon’thavetostopattheATMto
getmoneybeforeIgotoworktomorrow?’
Anotherconsiderationforsomeofusrelates to theeaseof
record keeping. If most of our transactions can be pushed
ontoasinglecreditcard,whichprovidesasingleconsolidated
69
creating a profitable infrastructureThe payments challenge for banks
Ann CairnsGlobal Head, Working Capital, ABN AMRO
route favored by some scale players, such as Citibank. But
bankswillneedtomaketheirownassessmentsofwhichbest
fitstheirowninstitution.
offshoring is here to stayPartandparceloforganizationaldecisionsarechoicesabout
whether or not to offshore. Whether institutions have the
capabilitytoexecuteoffshoringwithintheirexistingnetwork
ornot,anoffshoring2strategyisacriticalcomponentofany
paymentsstrategywherequality,productivityimprovement,
andreducedmanufacturingcostarekeycompetitivefactors.
Thedirectbenefitsofoffshoringareclear:Upto65%reduc-
tioninpaymentinstrumentunitprocessingcost,withsignifi-
cantqualityenhancementsgeneratingdownstreambenefits
incustomersatisfactionandreducedserviceandcorrective
costs.Additionalbenefitscomefromtheenormouscatalytic
effect of re-engineering processes that enable a relentless
pursuitofcontinuousqualityimprovement.
Somebanks,includingABNAMRO,havebeenabletosignifi-
cantlyenhancedisasterrecoveryandbusinesscontinuityby
introducing ‘load-sharing’ between regional and offshore
processinghubs.Thereducedriskofdisruptionisillustrated
bythefactthatfourpoweroutageandsecurityrelatedsite
denials in Western locations resulted in zero customer
impact,dueto theabilityof theoffshore facility toexecute
processing.Counterintuitivetoa‘Westisbest’outlook,per-
haps,buttruenevertheless.Infact,thekeyoffshoringdeci-
sionforbanksisnotwhethertooffshore,butwhethertodo
so in-house, by building their own facilities, or to select a
trusted provider — either a local company or a Regulated
FinancialInstitutionwithaprovenbusinessprocessoutsourc-
ingoffer.
A payments model appropriate to the parent institution’s strategyPaymentsbusinessgroupswithinbanksneedtodevelopstrat-
egies that maximize value for their parent. In essence, the
paymentschallengeisnodifferentfromthecommercialchal-
lengefacinganyotherbusiness. Ineverybusinessthereare
threecompetingbusinessthemes,customer-relationshipcen-
tric, product-innovation centric, or infrastructure manage-
ment centric. Different industry sectors (pharmaceuticals,
publishing, etc) offer examples of how organizations have
evolvedtounbundleconflictingcoreprocesses.Thebanking
andthepaymentsbusinessisnodifferent.Ittoowillconsistof
these three unique business characteristics which may con-
flictorbesuboptimal.Thechallengeistochoosewhichofthe
three models will add maximum value to clients and share-
holdersinthecontextofthestrategyoftheparentinstitution.
A customer-relationship businessRole:identify,attract,andbuildrelationshipswithcustomers.
Tasks:drawcustomersintothebank,assistthem,andtryto
build personal relationships with them, responding to ques-
tionsandcomplaints,collectingcustomerinformation,etc.
A product-innovation business Role: conceive of attractive new products and services and
commercializethem.
Tasks: research new products, figure out how to bring new
products/services best to the market, find ways to present
newproductstopotentialcustomers,etc.
An infrastructure businessRole: build and manage facilities for high-volume, repetitive
operationaltasks.
Tasks:buildnewbranches,maintaindatanetworks,provide
back-officetransactionalservices,managelogisticnetworks,
etc.3
Excelling at all three at the same time is incredibly difficult
and results in suboptimal contribution to theparent institu-
tion. For example, when we explore the economics we find
thateconomiesof scopeapply to thecustomer relationship
themewherehighcostofcustomeracquisitionandrelation-
shipmaintenancemakesitanimperativetogainlargeshare
of wallet, economies of speed apply to product innovation
aspectsofthebusinesswhererapidtimetomarketequatesto
70 - The Journal of financial transformation1 ArticleinComputerWeekly,13July2004
712 Formoreinformationaboutoffshoringpleaserefertothe8thissueofthis
Journal,whichwasdedicatedtothistopic.
3 Thisconcept,whichisevidentinourbusiness,isidentifiedanddevelopedby
Hagel,J.andM.Singer,1999,NetWorth:ShapingMarketsWhenCustomersMake
theRules,HBSPress
Onthefaceofit,thepaymentsindustryisthrivingasvolumes
continuetorisesteeply.In2003NACHAprocessed10billion
payments(up12%on2002),SWIFTvolumesgrewby9.5%on
2002(paymentsrepresent60%ofallSWIFTmessages),and
TheBankforInternationalSettlementsreporteddailyglobal
turnover in traditional foreign exchange markets of U.S.$1.9
trillioninApril2004,up36%atconstantexchangeratescom-
paredto2001.
But, as every payments executive knows, despite rising vol-
umesoverall,theindustryactuallyfacessomethingofacrisis.
Downwardpressureonpricingandthecostsofdoingbusiness
inanincreasinglycompetitiveandregulatedmarketplaceadd
uptoaverychallengingenvironmentforpaymentsproviders
in2005.
downward pressure on pricingPaymentsare, fundamentally,autilityusersarereluctantto
payfor.So-called‘freebanking’hasbeenthelifetimeexperi-
enceofmostadultsintheretailbankingsectorin,forexam-
ple,theNetherlandsandtheU.K.Businessestoohavebecome
much more demanding buyers of payment services over
recent years; reasonably enough, they negotiate hard with
theirbankersonpricingandtheyalsomanagetheirpayments
needscloselyusingsuchtoolsasinter-companynettingand
domestic non-urgent payment methods in preference to
cross-bordertransfers,andsoon.
Andgradualdownwardpressureonpricinghasbeensharply
accelerated in Europe by the introduction of the Single
EuropeanPaymentsArea.WithintheEuro-zone,cross-border
transfersofupto12,500mustnowbechargedasdomestic
transfers—thecapwillincreaseto50,000in2006.
cost drivers — technology renewal, market complexities, and regulation Meanwhile, the costs of providing the reliable and compre-
hensivepaymentsinfrastructuredemandedbyuserscontin-
ue to rise. Technology costs represent a huge and ongoing
burden,averagingaround20%ofthetotalcostbaseofpay-
ments organizations, according to market estimates. The
global IT investments (i.e. not just payments) of financial
institutions are an estimated U.S.$347 billion, according to
TowerGroup(2004).Atthesametime,thecostsofmeeting
regulatoryrequirementshavespiraled.Knowyourcustomer/
U.S.A.PatriotAct,BaselII,andSarbanes-Oxleytogetherrep-
resent significant costs. HSBC, for example, has calculated
thatthecostofmeetingregulatoryrequirementsis3.125%of
its Ebitda (earnings before interest, tax, depreciation, and
amortization)1.
The high costs of payments infrastructure have been com-
poundedinmostmarketsbylowinterestrates(onfloat)over
recentyears,addingtothedifficultiesforindividualpayment
providersofsupportingtheirpaymentsinfrastructures.While
this cost factor looks likely to improve going forward, the
othersarecertainlywithusforthelongerterm.
scale and size are different Thereceivedwisdomoverrecentyearshasbeenthatmarket
consolidationwillresolvethesechallengesthroughtheemer-
genceofafewmegaprovidersabletoprocesshighvolumes
ofpaymentsefficientlyandprofitably.Yetmergers,especially
cross-border,arehardtoachieveanddifficultinexecution.It
maybeseveralyearsbeforebenefitsstarttoberealized.And
evenifthedesiredscalecanbeacquiredinthisway,willthe
organizational structurebeable toexploit itefficiently?As
anyonewhohasspentmorethanfiveminutesinaverylarge
organizationknows,bigisnotalwaysbeautifulandtheday-
to-day realities of siloed businesses, fragmented infrastruc-
ture,andallocatedoverheadscanquicklydissipatethe‘scale
benefits’ofthetextbooks.
Sogettingtheorganizationalandsalesmodelsrightwillbe
everybitasimportanttoprofitabilityasassemblingthevol-
umebusiness.BostonConsultingGroup’sresearchhasdone
muchtoinformthinkinginthisarea.Ofthreeorganizational
models identified by BCG (infrastructure, customer centric,
andtransaction)thetransactionmodel(amono-line,custom-
er-facingentitywithfullP&Lresponsibility)appearstobethe
premiumpricingand largermarketshare,andeconomiesof
scale apply to any infrastructure business where high fixed
costsrequirelargevolumethroughputtodrivelowunitcost.
in or out: what is a bank to do? Whilechoiceoforganizationalmodelwillbecriticaltoexisting
or aspiring core infrastructure providers, other banks may
makeadifferentfundamentalchoice—thatofoutsourcingor
partneringtoresourcethepaymentsservicesthebankandits
customersneed.
Inmakingthisdecision,paymentsexecutiveswillobviouslybe
lookingtoshedtheinfrastructurecostsreferredtoabove,but
theyshouldalsobethinkingpositivelyaboutthebestwayto
enhancetheircorecapabilitiesandextendtheirreach,aswell
asmanagegrowthandriskforthefuture.
Whicheverpathaninstitutiontakes,thedecisionpointisnow
(or earlier!). Some banks are already incurring significant
lossesacrosstheirpaymentsfranchises,decisionsmadenow
concerning infrastructure changes will take some years for
the benefits to be realized, and banks that hesitate will be
evenmoreuncompetitiveonceearlieradoptersofnewbusi-
nessmodelsstart toreapthebenefitsof, forexample,new
technologyplatformsoroffshoringmodels.
Thosebankschoosingnottobeinfrastructureprovidersstill
have complex decisions to make. There is a spectrum of
choicefromoutsourcingaspecificserviceforaspecificmar-
ketsegmentorgeography(forexample,abankmaychooseto
outsourcealleuroclearingbutcontinuetocleardollarsthem-
selves) to fully private-labeled outsourced structures (for
example,front-andback-endprocessingforallcorporatepay-
ments). In the latter case, the bank would concentrate on
providinganeffectivesalescoverageapproachforpayments
asanadd-ontoother,value-addedfinancialservices.
In other cases, strategic partnerships may be founded on
mutual benefits, as with the partnership between Deutsche
Bank and Postbank4. In this interesting alliance, Deutsche
BankmovedalldomesticpaymentstoPostbankin2003,giv-
ingPostbanka15%shareoftheGermandomesticpayments
market.Thenearlierthisyear,DeutscheBanktookoverhan-
dlingofallPostbank’scross-borderbusiness.
Inthefuture,wecanexpecttoseebanksandfinancialinstitu-
tionspursuingstillmoreinnovativeorganizationalmodelsas
the market segments into core infrastructure providers and
thosefinancialinstitutionsthatchoosetooutsourcetheirpay-
mentsprocessing.Forboth,thechallengewillbetomaintain
organizationalclarityandflexibility,andcustomerresponsive-
ness,astheystrivetobecomeorremainprofitable.
72 - The Journal of financial transformation4 DiscussedinmoredetailbyWolfgangGaertnerinthisissueoftheJournal.
734 DiscussedinmoredetailbyWolfgangGaertnerinthisissueoftheJournal.
Payments in transition: where have all the changes gone?Mark WebsterPartner, Capco
Formanyyears,punditshavebeenpredictingthedawnofa
cashlessandchecklessworldandthedemiseofmoretradi-
tionaltransactionmethods.IntheU.S.specifically,the‘death
ofthecheck’hasbeenheraldedanddiscussedforatleastthe
last thirty years. The reality is, however, that the uptake of
newandimprovedpaymentsproductshasbeenmuchslower
thananticipated.Paper-basedmanualpaymentssystemsare
stillprevalentandmostbanksarestillusingpaymentsplat-
formsandarchitectures thathad theirgenesis in the 1960s
and70s.Giventhebroadspreadacceptanceofpersonalcom-
puters and Internet communication, the question becomes
whyhasthepaymentsindustrybeensoslowtochange?
drivers of changeBytheirnature,financialinstitutionsareinherentlyconserva-
tiveandriskaverse.Barringregulatorydemand,changeusu-
allytakesplaceveryslowly,almostcomingtoacompletehalt
without some strong motivation. The typical drivers for
changeinbankingtendtobecostcontrolorefficiency,cus-
tomer demand (revenue pressure), and risk control. While
eachoftheseareascanbeaffectedbytransformationofpay-
mentssystems,theoverall impactofthesedrivershasbeen
lessthanimpressive,intermsofmandatingchange.
The foundations of much of the current payments system
infrastructurehavebeeninplacesincethe1960s.Asbusiness
andconsumerdemandforfinancialtransactionsincreasedin
apost-WorldWarIIerathepublicandprivatesectors,inthe
formofbanksandcentralbanks,joinedtogethertocreatean
incredibly large and sophisticated infrastructure to manage
the flow of paper-based transactions, primarily checks. As
volumesgrew,existingprocesseswereautomatedtoimprove
efficiencyandentirebusinessesgrewuparoundmeetingthe
needs of the check-processing industry. The end result has
beenthecreationofalargebaseoffixedcostsdedicatedto
processing manual transactions. Electronic transactions are
arguablymorecosteffectivethancorrespondingpaper-based
ones,onapertransactionbasis.However,whenthecostsof
supportingtheexistinginfrastructureareincluded,thebusi-
ness case for change becomes questionable. As will be dis-
cussedlater,thissituationisexacerbatedbythefactthatfew
banks look at payments holistically. Most banks operate in
silosandhavecreatedseparateoperationalentitiesforpaper
andelectronicpayments.Thismakesitdifficulttodetermine
the overall economic impact of changes in transaction pat-
ternsandresultsincontinuedinvestmentinexistingsystems
thathavealreadyreachedscaleeconomy,ratherthaninvest-
inginnewerunprovenpaymentsvehiclesandplatforms.This
situation is changing as maintenance costs for aging pay-
mentsplatformsincreases.Butatthemoment,bankstendto
be more focused on increasing the cost efficiency of their
existing payments products rather than making extensive
investmentsinnewsystems.
Theeconomicsituationiscomplicatedbythesurprisinglack
of customer demand for newer payments products. Con-
sumershavebeenveryslowtomovefrompapertoelectronic
payments.Despiteavarietyofmarketingcampaignsbybanks,
retailers,andtradeassociations, ithasonlybeen inthe last
yearthatthevolumeofretailelectronicpayments,primarily
cardandACH,hasequaledthatofthepaper-basedmarketin
the U.S. Businesses have been even slower to change their
paymenthabits.Tradeorganizations,suchastheAssociation
ofFinancialProfessionals(formerlytheTreasuryManagement
Association),havemadeitveryclearthatchecksarethepre-
ferred method of payment, at least from the disbursement
sideofthehouse.Thislackofdemandhasmadeitdifficultfor
bankstojustifyhugeinvestmentsinnewpaymentsinfrastruc-
ture.Facedwithtakingtheriskthat ‘ifyoubuild it, theywill
come,’ banks have again focused on improving the overall
efficiencyoftraditionalpaymentsplatforms,andonlymaking
limitedinvestmentsinnewersystems.
Thethirdpotentialdriverofchangeisriskcontrol.Thiscan
belookedatfromseveralpointsofview.Firstly,itistheissue
of transactional risk control. Banks and corporations have
spentsignificanttimeandmoneydevelopingtechnologyand
processes to control and manage the risk of check fraud.
Although check fraud is a growing concern for most banks
andmanycorporations,fewconsumersseecheckfraudasa
major issue.Bycomparison,bothbanksandconsumersare
increasingly concerned about credit and debit card fraud.
Bankshavespentlargeamountsoftimeandmoneydevelop-
ingwaystocontroltheriskofcardfraud,butlossescontinue
to climb and consumers’ fears, largely due to growing con-
cernaboutidentitytheft,continuetoincrease.Asaresult,at
leastforthemoment,transactionalriskdoesnotseemtobe
an adequate reason to radically change payments systems.
The second point of view is that of operational risk. The
increasing cost of maintaining existing payments platforms
maybean incentive tomovetowardsnewerandmoreeffi-
cientplatforms.Aspreviouslymentioned,muchoftheexist-
ing payments infrastructure has been in place for thirty to
fortyyears.Althoughthesystemsandtechnologyhavebeen
updatedandmodifiedovertime,theiroverallcomplexityand
the related cost of maintenance continues to grow. Despite
the increasing cost, however, the existing systems do work,
andastheoldadagesays‘ifitain’tbroke,don’tfixit.’
Barriers to changeWhilethedriversforchangemaybemixed,barriersprevent-
ingitaresignificant.Hereagainwecanlookatrisk,revenue
orcustomerdemand,andcostefficiency.Ineachcase,there
arefactorsthatcreatepotentialbarrierstoanychangebar-
ringabsolutenecessity.
Payments are a core function for financial institutions.
Various studies have indicated that payments account for
30% to 40% of total net banking revenue. Understandably,
mostbanksarehesitanttomakemajorchangestocoresys-
temsinabigbangapproachwhensomuchoftheirrevenueis
atstake.Theriskofpotentialfailureisjusttoohigh.Unfortun-
ately, thesamecomplexityandageofexistingsystemsthat
increases maintenance costs also makes it difficult to make
significantchangesincrementally.Asaresult,majorchanges
inexistingsystemstendtobedeferredifatallpossible.
Although referred to earlier as surprising, the lack of cus-
tomer demand for new and improved payments systems is
actually not that surprising at all. Most consumers tend to
resistchangeunlessthere issomestrongincentivetomake
thechange.Inthecaseofpayments,onemightexpectthisto
be an economic incentive, given that electronic payments
shouldbecheaperandmoreconvenientthanthecorrespond-
ingcheck-basedones.Whilethismightbeatruestatementon
an all-in cost basis, most customers, whether consumers or
corporations,donotseeitthisway,mainlybecausethereis
lack of transparency in payments processing costs in the
bankingindustry.Veryfewbankcustomersseetheactualcost
of check writing as a disbursement method. Rather than
charging transaction fees, most banks recover their costs
through a combination of float and exception item service
chargesforcheckwritersanddepositchargesleviedoncom-
mercialcustomers.Infact,manyU.S.bankshaveextensivead
campaigns around variations on the theme of totally free
checking.Evenforcommercialcustomers,theper-transaction
or‘pennyprice’forindividualchecksisrarelyequaltoitstrue
cost.Thisapparent subsidyof checkwritingby thebanking
industry provides customers a strong incentive to stay with
theirtraditionalhabitsofwritingchecks,whilecheckreceivers
burytheircostsinthepricesthattheychargetheend-users.
Thislackoftransparencyisalsoanissuewithinmostbanks.
Aspreviouslymentioned,mostbanksarehighlysiloedwhenit
comestopaymentsplatforms.Veryfewbankshavetheability
tolookatpaymentsasawholeandhavedifficultyapportion-
ingcostsandrevenuesacrossvariouspaymentchannelsand
platforms.Asaresult,decisionsareoftenmadebasedonan
incompleteunderstandingoftheimpactofchangeonallpay-
ments products. While free checking may be viewed as a
neededprerequisitetomaintainingdemandaccountbalances,
electronic transactions are fully charged, resulting in an
added customer disincentive to change. Additionally, invest-
mentdecisionsareoftenmadebasedupontherelativesize
and importanceofthepaymentchannel,ratherthanonthe
long-termstrategic interestsofthefinancial institution.This
tendstofavorexistingpaymentssystemsandplatformsthat
havealreadydevelopedscalevolume.
Finally,fromacostefficiencypointofview,paymentsprocess-
74 - The Journal of financial transformation
75
ingisahighlycomplexnetworksystem.Thisisespeciallytrue
intheU.S.,sincetherearealargenumberoffinancialinstitu-
tionsthatclearpayments.Inlargesystemsofthistype,par-
ticipantsarehighlydependentupontheactionsofothernet-
workparticipants.Onebankcannotchangetoamoreefficient
methodofprocessingpaymentsunlessasignificantnumber
oftheotherparticipantsmakeasimilarchange.Asaresult,in
a variation on the traditional concept of ‘The Prisoner’s
Dilemma’ingamingtheory,thenetworktendstosuboptimize
anddiscouragechange.Sinceeveryonecanprocesschecks,
we continue to process them and there is little movement
towardsmoreefficientpaymentmethods.
conclusionWhile the economic transparency of our various payments
systems isunlikely to improveany timesoon,end-usersare
findingotherreasonstodemandincremental,ifnotovernight,
change. Decades of such incremental changes have already
hadsignificanteffectsonbothcheckandelectronicpayments
systems. Over time, we have gradually built an electronic
infrastructure that can effectively parallel existing paper-
basedsystems.Theincreasingageoftheexistingsystemswill
eventually force a transition as maintenance and operating
costscontinuetoincrease.Regulatoryissues,suchasCheck
21intheU.S.,imageprocessingmandatesinpartsofAsiaPac,
andpricingharmonizationintheE.U.,willonlyacceleratethe
rateofchange.
Wemayneverseeatotallycashlessandchecklesssociety,but
the transition to more integrated and automated payments
systemsishappening.Ratherthantherevolutioninpayments
thatwasoncepredicted,weareinthemidstofanevolution,
aslowseachangethatwilloccurwithoutmostofuseverreal-
izingthattherehasevenbeenachange.Howwegetthereis
perhapsnotas importantasthefactthatwewilleventually
get there. And by then, the pundits will be predicting even
moreradicalchanges!
76 - The Journal of financial transformation
OnceuponatimeaBankCEOreceivedaphonecallfromhis
motheronChristmasEve.
—‘Ican’tgetanymoneyoutfromtheATMformylastmin-
uteshopping,theBankbranchhaslongqueuesand
Icouldn’tusemyBankcardatthesupermarket,’she
exclaimed.
—‘Don’tworry,I’lllookintoit’,hereplied,thinkingthiswasa
minorproblemashepreparedforhisannualtalktothe
seniorexecutivesoversherryandmincepies.
He called the operations center; ‘Actually the Bank’s whole
ATMandPOSnetworkisoutofoperationanditisunlikelythat
wecanrecoverthesituationforanothertwohours,’reported
thedutymanager,lumpinthroat.Theimplicationsalmostdo
notbearthinkingabout;theCEOknewthat25%oftheentire
country’selectronicpaymentsnetworkwasoutofactionon
thebusiestshoppingdayoftheyear.
WhydidtheCEOnotknow?Whataretheramificationsfrom
the merchant business customers and card holding clients?
How long and how much will it cost to handle the manual
transactions generated from the outage? What does this
meantotheBank’sreputationandbrand?Thisisabusiness
whoseraisond’êtrehasbeenbasedontechnologytodeliver
convenience;evenhismother reliesonelectronicpayments
mechanisms.
How many times have we heard it? ‘This business needs to
improveclientservicelevels,adapttochangingcircumstanc-
es,increaserevenue,andreducecosts.’Thefinancialservices
industryislitteredwithexamplesofnotheedingtoorexecut-
ingsuccessfullyaround thesecore facets.Forexample,new
entrantsinmortgages,on-linesharetrading,andinsurancein
thelasttenyearshavechangedthemarketpermanently.The
top ten in many lists of vertical product suppliers will have
changedbeyondrecognitioninthelastdecadeinmostdevel-
opedcountries.
However,paymentshavenotbeentestedandthreatenedas
dramaticallyinthatperiod.Whynot?Thebottomlineisthat
payments have to be fulfilled as a core mechanism in our
economies.The risks, scale, security, andcomplexity cannot
be underestimated in delivering a successful payments net-
workwithappropriateregulationtoensurethatthenecessary
robustness,safetymechanisms,andcompetitiveframeworks
are in place. The inertia to change and the high barriers to
entryhavebeendictatedbysophisticatedgroupingsofinter-
ests, includinggovernmentsandregulatorybodies, financial
institutions, large payments processors, large retailers, con-
sumergroups,andserviceandtechnologysuppliers.
The above story actually illustrates only one aspect of the
increasing pressures on payments processing to deliver
improvedandnewservicesatasignificantlylowercost. It is
possible that this Bank had driven costs down through low
investment in aging infrastructure, asset depreciation, and
staffreductions.Astransactionvolumeshaveincreasedand
layer upon layer of complexity introduced, the system has
reacheditscapacityandfailed.
Payments processors are facing a difficult equation. They
havetoassesswhetherthecommercialrisksofnotchanging
theirbusinessprocessesandinfrastructurearegreaterthan
therisksassociatedwithtechnologicalchange inoneofthe
most demanding of all IT and telecommunications environ-
ments.
Outsourcingremainsanotheroptionwherebankshavecon-
tracted either specialist third-party payments processors or
major outsourcing organizations to operate their IT infra-
structure.Evidencesuggeststhattheseoutsourceoperations
actually have the same problems as the original payments
institution, namely; limited differentiation, rigid processes,
ageing infrastructure, and costs levels that do not support
newmarketmodelsandcompetitivedynamics.
Whilst it is relatively straightforward to argue that a bank’s
core business may not be operating a Point of Sale (POS)
terminalfleet,theadvantagestothebankinclude:Revenue/
Electronic payments:The drive towards a competitive, customer service driven utility
Rod DewMarketing Director, Distra Pty Ltd
77
profitability,adirecttouchpointwiththebusinesscustomer,
service differentiation, and cross-selling opportunities. It is
possible that outsourced or central switch initiatives could
dilute the bank’s brand and disintermediate the bank’s rela-
tionship with the merchant customer, as witnessed in the
UnitedStatesandbysmallerfinancialinstitutionsthatutilize
outsourcedpaymentsservices.
merchants demanding moreMerchants have become increasingly dissatisfied with the
levelofserviceofferedbythepaymentsnetwork.Currently,a
typical model includes paying rental for the Point of Sale
devicesandtelecommunicationsline,andafeeforeachtrans-
action processed. The transaction fees cover both the pro-
cessing and support costs of the acquiring operation and
fraudandotherrisksfacedbythecardissuer.
Settlement, the movement of funds from the cardholder’s
accounttothatofthemerchant,cantakedays,andtransac-
tionsthataredisputedcantakeweekstoresolve.Thee-pay-
mentsPOSdevicesaregenerallynotintegratedwithin-house
networks,inventoryandfinancialmanagementsystems.
These factors have led to high rates of churn at the small
retailer end of the market, driven by marginal fee benefits,
andforlargerretailerstodeploytheirowninfrastructure(or
retailer led outsourcing/ consortiums) to negotiate better
transactionfeetermsandlowerinfrastructurecosts.
An opportunity exists for enterprising payments processors
andmerchantacquiringbankstogrowmarketsharebyprovid-
inggreaterinformationvisibility(on-linetransactionreporting
services, self service, dispute reconciliation), reduced settle-
ment times, and improved financial services, examining the
broader business needs, such as cash flow requirements,
supplierchainintegration,insurance,leasingetc.
other significant market changes impacting the status quoWhilstmerchantpressureishavingarealimpactonthepay-
mentsnetwork,thereareanumberofotherforcesofchange
thatareleadingtoare-assessmentofthepaymentsbusiness.
Thefollowingprovidesasummary:
Regulation—anincreasingnumberofregulationsareimpact-
ing payments processing globally. These include Check 21
(check image capture at the Point of Sale in the U.S.), the
Patriot Act (determining disclosure obligations on money
laundering),BasleII(operationriskcapitaladequacy—asper
thestoryreferredinthispaper),reducedpaymentsnetwork
fees, and greater transparency (Reserve Bank of Australia
creditcardreformsandEFTPOSnetworkdesignation,andthe
TreasurySelectCommitteeenquiriesintheU.K.).
Role of card schemes—potentialcentralswitchingmodelsin
Asiancountriesaimtocircumventtheperceivedexpenseof
utilizingthecardschemesasswitchprocessors.Additionally,
U.S.merchantshave fought successfully for the loweringof
debitcardtransactionfeesfortransactionsprocessedthrough
thecardschemenetworks.
Fraud—increasingcardfraudhasledtonationalmandatesto
deploy smart card technology (EMV). This typically requires
the deployment of new terminals and card readers, and
changestothecoreprocessingsoftware.
new channels and transactions—growth inATMandPOS
usagecontinuesunabated.However,newerchannels,suchas
theinternetandmobilenetworks,aregainingsignificantlev-
elsofmarketacceptance.POSdevicescanalsobeextended
to provide banking services, such as funds transfer and bill
payment,andothertransactiontypes,suchasticketing.New
transaction types include health insurance payments, P2P
payments, loyaltyschemes,mass transit systems ticketpur-
chase, etc. Payments processors need to evolve to support
multi-currencyandchannelintegrationcapabilities,andmore
thanjuststandardfinancialtransactions.
communications—ATMandPOSnetworkshavebeendomi-
nated by proprietary, costly communications infrastructure.
78 - The Journal of financial transformation
TransactionsaretypicallyaggregatedbyTelcosandforward-
edontopaymentsprocessors.Withtheadventofubiquitous
InternetProtocol(IP)thepotentialisfor‘alwayson’devicesto
routetransactionstopreferredprocessors.Thelegacyaggre-
gationservicesarethreatenedandpaymentsprocessorswill
bedriventowardsdifferentiationbeyondterminalconnectivi-
tyandfinancialtransactionprocessing.
Payments convergence—paymentsprocessinghastypically
beenmanagedthroughlinesofbusiness.However,anenter-
priseviewofpaymentscouldleadtogreaterefficienciesand
theproductionofnewproducts/services.Thesameenviron-
mentcouldsupportB2B,P2P,billpayments,highvalue/lower
volume payments, high volume/lower value payments, sup-
plierpayments,etc.
The technology challengeThecomplexityandscaleofthepaymentsswitchingprocess
cannot be underestimated. For example a large payments
processor may handle millions of real-time authorization
transactions a day from in excess of 100,000 POS/ ATMs
devicesplusinternet,mobile,andvoucherchannels.Ithasto
settlefundswithcardissuinginstitutions,cardschemes,and
tensofthousandsofmerchants.Thecostsofmanagingdis-
puteprocessesaresignificant. Inaddition,thesystemshave
toprovide24x7operationstoallowconsumerstotransact
anywhereatanytime.
However, tomeet thedemandsdescribedabove,processors
needtoexaminetheirexisting infrastructureandassessthe
migration risks of moving to new business models, a lower
cost model, and new communications, software, and plat-
forms.
Large payments processors have had very little choice in
selecting the necessary high performance transaction
processing environments needed to drive large payments
networks. Typically, the solutions have utilized in-house or
heavily customized vendor software operating on either
mainframesorhigh-endserversforhighavailabilityandfault
tolerance.
Awaveofsecondgenerationsolutionshasprovidedsoftware
on open platforms (UNIX, NT etc.). However, to provide the
levelsoffaulttoleranceassociatedwiththemainframes/high
end servers, clustering and replication techniques are
deployed.The limitationof thesearchitectureshas included
reducedperformanceandscalabilitydimensionsandextreme-
ly complex recovery issues in the event of a partial system
failure. Whilst these solutions are more flexible and open,
thereisstillaheavyrelianceontheoriginalsoftwarevendor
tocustomizethesoftware.
Thenextgenerationofpaymentssolutionsnowofferatruly
open and adaptable environment, unlimited scalability, and,
importantly,faulttoleranceattheapplicationlevelthrougha
distributedarchitecture.Costsaredrivenoutthroughchoice
ofdeveloper/integrator,useofmarket standard serversand
databases,speedtomarketfornewservices, lowerupgrade
costs, and utility models for license fees and infrastructure.
Transaction information isavailable inrealtimefordistribu-
tion to merchants, banks, and senior management via web
interfaces.Thenextgenerationapplicationdeliversasignifi-
cantly lowercostbase,greaterbusinessagility,andactually
improved reliability through enhanced replication and moni-
toring.
conclusionIndeliveringasecure, trustedpaymentsnetwork,payments
participantshavefocusedonnetworkcentricissuestoexpand
andgrowtheirbusinesses.Thenewdimension is toprovide
client-centric services; value for money, faster settlement
processes, value-added services, new channels, and greater
convenienceandtransparency.
Thecostsandrisksassociatedwithchangingtonewbusiness
modelsandapproaches,coupledwiththepotentialcannibal-
izationofexistingrevenuestreams,havehinderedinnovation
andresponsiveness.Thechallengeforexistingpaymentspro-
cessorsistoeitherreducetheircostsandadaptorbesubject
79
toagradualerosionoftheirbusiness.
However,therealopportunityisforlargeprocessorsandnew
entrantstoexploitthemarketchangesbyprovidingconsoli-
dated services that do not disintermediate the existing net-
workoperators.Thismaybeachievedbyprovidingdifferenti-
atedservicesandrevenuesharingmodelstobanksandmer-
chants within the network on the same infrastructure. The
ultimate vision is to deliver electronic payments as a utility
serviceacrossmultiplechannelsatanational, regional,and
potentiallyagloballevel.Acompetitivedynamicismaintained
by leveraging the infrastructure to support value added
aspectsforparticularnetworkrelationships.
Indefiningthestepstodeliveronnewstrategies,technology
has to be a high consideration. The ability to differentiate
service,adapt,providescale,anddeliverthehighestlevelof
availabilityarecomplexdimensionstoorchestrate.Importantly,
risksmaybemanagedthroughaphasedintroductionofnext
generation technology. The solution needs to meet existing
functionalandservicelevelrequirementsaswellasrealizing
the core benefits; reduced costs, increased business agility,
andimprovedservicelevels.
The payments processor’s challenge is identifying what is
trulyopen,whatwilldelivertoday’srequirements,andwhat
will rapidly adapt to meet an ever changing and dynamic
market.
Transition
simulation: A powerful research tool in payment and settlement systems
Harry leinonenAdviser to the Board, Financial Markets,
Bank of Finland1
Kimmo soramäkiPolicy Expert, Directorate General Payment
Systems and Market Infrastructures, European Central Bank
Abstract
Paymentsystemsarecomplicatedandcontainmanyinternal
andexternaldependencies.Societyisdependentonwellfunc-
tioningpaymentinfrastructuresanditsstabilityandefficiency
bothrequirecontinuousmonitoring.Itisdifficult,ifnotimpos-
sible, to test different kind of risk scenarios and policy or
structural changes in daily production systems. Simulation
models, payment system simulators, provide a powerful
research tool for payment and settlement system analysis.
Thisarticledescribesthegeneralstructuresanddimensions
ofpaymentsystemsandthepossibilitiesofapaymentsystem
simulationapproach.
811 Theviewsexpressedarethoseoftheauthorsanddonotnecessarilyreflectthe
viewsoftheBankofFinlandortheEuropeanCentralBank.
simulation: A powerful research tool in payment and settlement systems
simulation — the possibilitiesThe development of payment and settlement systems often
involves the hands-on work of designing and operating sys-
tems.Theanalyticalworkmusttackletheproblemofhandling
of largeamountsofdataand transactions.Simulation tech-
niquesenabletheconstructionofmodelsthatcloselymimic
therealworld.Thegenericeconometricmodelsaretoolimit-
ed to deal in sufficient detail with the many dimensions of
paymentsystems,whichentailimportantdependencies,both
within and between systems. Decision-making and other
behaviorissuesareheuristicanddependentoncounterparty
andsituation.Forthisreason,paymentsystemmodelsmust
allowfortheembeddingofdifferentkindsofbehaviormodels.
Areality-friendlysimulationmodelprovidesaveritablelabo-
ratorysetting,inwhichonecananalyzetheprobableaffects
of different structural options and decision parameters on
payment flows and system participants. An on-stream pay-
mentsystemissosensitivethatonecannotuseitfordirect
experimentationwithoutendangeringdailyoperations.
Anotherareaofresearchisthestudyofdifferentcrisissce-
nariosandhowtoprepareforthem.Whilerealizationsofsuch
crisisscenariosareextremelyrare,simulationmodelsenable
onetostudynumerouscrisis-likesituationsandthustopre-
pareinadvancefortherealevent.
Nonetheless, simulation models are subject to their own
important limitations. Optimization analysis requires com-
plete enumeration and iteration, so that one may actually
miss the true optimum. There may be problems with the
behavioral models and assumptions, which may not hold in
certainspecial situations. It is fairlysimple tousepayment-
flowtimeseries insimulationstudies,but thismayresult in
thefailuretodetecttheimpactoffuturechangesinpayment
flows.
Basic structures of payment systemsTraditionally,paymentsystemshaveoperatedonthebasisof
batch-processingandsystem-specific timetables.At theend
oftheday,anetpositioniscalculatedfrompaymentflowsfor
eachparticipatingbank.Insuchdeferrednetsettlementsys-
tems(DNS),coveringfundsareusuallytransferred,withalag,
acrossaccountsat centralbanks. Inorder to speeduppay-
menttransfers,especiallyforlargepayments,onlinecontinu-
ous settlement systems (CNS) have been developed. But
because a netting system can give rise to large inter-bank
creditriskpositions,authoritieshavegenerallyrequiredthat
theserisksbelimitedorhaveprovidedintheirsteadreal-time
grosssettlementsystems(RTGS).
Payment and settlement systems are often hierarchically
structured.Thetoplevelcomprisescentralbanks’RTGSsys-
tems,wherelargepaymenttransfersareexecuted,inter-bank
debitsandcreditsaresettled,andothersystems’finaltrans-
fersofcoveringfundsareaffected.Forexample,theBankof
Finland’sRTGSsystem(BoF-RTGS)handles inter-bank trans-
fersofcoveringfundsforcertainotherFinnishsystems:Retail
payment system (PMJ), express and check transfer system
(POPS),andtwosecuritiessettlementsystems(OMforshares
andRMfordebtinstruments).Theinternationaldimensionof
the BoF-RTGS is represented by its continuous linkage with
the European System of Central Banks’ TARGET system,
through which covering funds are transferred for systems
handlingprivatelarge-valuepaymentsinEurope(EURO1)and
internationalcurrencytransactions(CLS).Figure12showsthe
hierarchicalstructureofpaymentandsettlementsystemnet-
worksingeneral.
Risk considerationsLarge inter-bankriskpositionscanarise inanettingsystem
because banks accept incoming payments on behalf of cus-
tomersbeforecoveringfundsaretransferredbetweenbanks.
G10 central banks’ Committee on Payment and Settlement
Systems,initsLamfalussyreport[BIS(1990)],focusedatten-
tion on this type of risk. Authorities then proceeded to
demand that private netting systems employ limits and col-
lateralrequirementsforriskcontrolpurposes.Thereportalso
promotedthedevelopmentofRTGSsystemsbycentralbanks
[BIS(1997)].Andinordertoreducerisks,coreprincipleshave
82 - The Journal of financial transformation
simulation: A powerful research tool in payment and settlement systems
83
Thelastseveralyearshaveseenagrowinginterestinresearch
anddevelopment in inter-bankpaymentandsettlementsys-
tems. Central banks have allocated effort and resources to
thisspecialarea.Amongthefactorsbehindthemovementare
internationalcooperation,technologicaladvancement,grow-
ingdependencyonsmoothfunctioningpaymentsystems,and
riskperspectives.Cooperationhasbeenaparticularlyimpor-
tant factor in theEuro-zonearea,whichhas seenextensive
linking of payment systems in order to give the region a
totallyintegratedinter-bankpaymentsystem.Thekeyofficial
fora have been payment system committees of G10 central
banks and of the European System of Central Banks, and
workinggroupsoftheEuropeanCommission.
AttheBankofFinland,simulationmethodshavebeenusedfor
severalyearsintheanalysisofpaymentsystems.Thistypeof
researchwasinitiatedaroundthetimeFinlandwasjoiningthe
Economic and Monetary Union and it became necessary to
examinetheimpactthatthenewmethodsoftransferringpay-
ments and covering funds would have on Finnish payment
systems.Outofthisconcernevolvedtheconstructionofthe
firstpaymentsystemsimulator.Thesimulatorprovedtobean
excellent tool for studying liquidity needs and system risks.
Althoughthesimulatorwasnotintendedforoutsideuse,other
centralbanksmadeuseofitwiththehelpofBankofFinland.
ExperiencewiththesystempromptedtheBankofFinlandto
proceedwiththedevelopmentofanewandmorediversified
simulator, designed especially for external use and interna-
tional distribution. The new simulator, BoF-PSS2, was com-
pletedinSpring2004andisavailableforresearchpurposes
freeofcharge.
Thepurposeofthisarticleistointroducethebasicissuesand
research topics related to payment systems that have been
studiedwiththeaidofsimulationmodelsaswellasthepos-
sibilities for using the Bank of Finland simulator. A more
detaileddescriptionofpaymentsystemfeaturesandinterest-
ingtopicsforsimulationstudiescanbefoundinLeinonenand
Soramäki(2003).
RT
gs
lev
elc
ns
lev
eld
ns
lev
el
DomesticcurrencyForeign
currenciesBonds Shares Derivatives
End-of-periodRTGSsettlement
End-of-periodRTGSsettlement
DVP-conditions
DVP-conditionsPVP-condition
RTgs 1 RTgs j RTgs k RTgs mbonds
RTgs nshares
RTgs pderivatives
dns r dns s dns ubonds
dns vshares
dns wderivatives
cns b
End-of-periodRTGSsettlement
cns b bonds
Intradayliquidity
injections
Figure1:Hierarchicalstructureofpaymentandsettlementsystems
2 Figure1illustratesthelinkagesforsimpleandconditionalfundstransfers.Incon-
nectionwithsecuritiessettlementsystems,deliveryversuspayment(DVP)means
thatdeliveryofsecuritiesisconditionalonsimultaneouspayment.Paymentver-
suspayment(PVP)referstocurrencytradinginwhichpaymentinonecurrency
occursonlysimultaneouslywithcorrespondingpaymentintheothercurrency.
DVPandPVPweredevelopedasmeansofreducingsettlementrisk.
simulation: A powerful research tool in payment and settlement systems
settlementprocess.Certaintimingmethodscanalsobeused
forthesepurposes.InFigure2thedottedlineshowsthepos-
siblebenefitsofasettlementalgorithmthatsolvesgridlock
situationsinthesystem.Insuchsituations,theparties’trans-
actionsarequeuedandcannotbesettledindividuallyone-by-
onebutcouldbesettledbynettingorsplitting[Leinonenand
Soramäki(1999)].Atypicalexampleisacircularsituationin
whichparticipantAispayingparticipantB,whoispayingpar-
ticipantC,whoispayingparticipantA;butnoonehassuffi-
cientliquiditytopayandthusbreakthecircle.
In seeking a partial netting solution, one encounters the
‘knapsack’problem.Thisariseswhenliquidityisnotsufficient
tocompleteallthetransactionsinaqueueandonemustcom-
poseasmallergroupoftransactionsforsettlement.Inseek-
ing an optimal combination of transactions to settle, one is
facedwithsomanypossibilitiesthatgoingthroughthewhole
list isan inefficientprocedure.Algorithmsarepubliclyavail-
ablethatfindtheoptimalsolutioniftheorderofpaymentsis
fixed[BechandSoramäki(2001,2002)]andanapproximately
optimalsolutionifpaymentscanbesettledinanyorderfrom
thequeues[Guentzeretal.(1998)].Theproblemofgridlockis
particularly acute in securities settlement systems that
requiredeliveryversuspayment(participantsmusthavesuf-
ficientmoneyandsecurities).
cost elementsSettlement systems entail three structural cost factors that
are partly interdependent: Liquidity, delay, and credit-risk
costs.Liquidity,suchasholdingsoffundsforcompletingset-
tlements,involvescertaincosts.Theseare,asidefromstorage
costs,mostlyopportunitycosts,sincetheinterestrateoneli-
giblecollateralisusuallylowerthanonotherinvestments,due
to the liquidity premium. If settlements and the underlying
payments are late, delay costs arise, mostly in the form of
sanctions. If the payment system operates on the basis of
credit,usersalsoincurcreditriskcosts.Thebasicstructural
interdependenciesofcostelementsaredepictedinFigure34.
Besidesstructuralcosts,everysystemencountersprocessing
costs.Theseare,however,generallyof thesamemagnitude
regardlessofstructuraloptionanddependmainlyontheeffi-
ciencyofunderlyingcomputersystems.
Credit risk costs do not arise if the system operates com-
pletely on the basis of liquidity. If settlement is wholly or
partlybasedon implicitcreditrelationsbetweenthepartici-
pants, the cost of liquidity will be smaller. The difference,
however, is that liquidity costs fall on sending parties while
credit risk costs are reduced for receiving parties. Similarly,
liquiditycostscanbereducedbydelayingoutgoingpayments
so that they are in synchrony with incoming payments and
thusbenefitfromthenettingeffect.
Delaysinsettlementanddeliveryareusuallycausedbylimits
onavailableliquidityandonpermittedcreditrisks.Inpractice,
delays are greater, the less the liquidity available and the
tighter thecontrolofcredit risks. In their roleasoverseers,
centralbankshaveusuallyattemptedto increase liquidity in
ordertoensureadherencetopaymentprocessingtimetables.
Atthesametime,theyhaverequiredreductionsandcompen-
sation via liquidity transfers, especially to avoid large risk
positions.Figure3givesanexampleofasystem(A)basedon
fullliquidityandasystem(B)basedoncredit.
843 Therelationshipbetweenliquidityneedsandsettlementspeedisstudiedin
KoponenandSoramäki(1998)andLeinonenandSoramäki(1999).
Pay
men
td
elay
s
Liquidityavailable
Lowerbound Upperbound
4 2
3
1
Figure2:Relationbetweenliquidityandsettlementspeed
simulation: A powerful research tool in payment and settlement systems
beendrawnup for systemically importantpayment systems
[BIS(2001)].
Insomepaymentsystems,counterpartyriskscanbesolarge
astogiverisetothethreatofadominoeffect.Financialprob-
lemsofoneparticipantcanbetransmittedviapaymentsys-
temstootherparticipantssoastocreateasystemicriskto
thewholefinancialsector.Integrationofpaymentsystemshas
increased the likelihood of contagion of systemic risk situa-
tions across wide areas of the globe. Authorities have
attemptedto limittherealizationprobabilityofsuchriskby,
forexample,requiringgrosstransfersofcoveringfundsand
collateral coverage of all significant counterparty positions.
Systemic risk has also become an important research topic
[Angelini et al. (1995), Kuussaari (1996), and Bech et al.
(2002)].
Liquidityriskisrelatedtopossibleshortfallsoffundsforset-
tlingpaymentobligations.Banksdoattempttoforecasttheir
comingliquidityneeds,butpaymentflowsaresubjecttodiffi-
cult-to-forecast stochastic fluctuations. These fluctuations
may be troublesome, especially in times of market distur-
banceorwhenotherbanksinthesystemarefacingliquidity
problems.Realizationofliquidityrisksmayevencauseatem-
porarydisruptiontoalargepartofthepaymentsflows.
liquidity needsLiquidity needs of payment systems and participants vary
accordingtotimetablesandsystemfeatures.Figure2givesa
generalpictureofliquidityneeds.Thelowerboundappliesto
theendoftheperiod,i.e.,itistheminimumamountofliquid-
ityneededtosettleallpaymentsbytheendoftheday.Ifthe
finalinter-banksettlementandtransferofcoverarenotcar-
riedoutuntiltheendoftheperiod, it issufficientthateach
counterpartyhassettlementfundsavailableintheamountof
its net liability. Settlement in this case is delayed for the
maximum time (point 2). In case payments are settled con-
tinuously with this same amount of liquidity and queued
whenever not enough liquidity is available, the settlement
delayscanbereduced(point3).
The upper bound (point 1) applies to continuous real-time
settlement. Payments are settled immediately and liquidity
needismaximized.Anyliquidityinexcessofthisamountwill
notbeused.Betweentheseextremesituationsisacontinuum
ofoptionsforwhichsettlementisdelayedandpaymentsare
variously queued. The shape of the curve depends on the
extentofthecontinuousnettingeffect.Ifliquidityisreduced
belowpoint3somepaymentswillnecessarilyremainunset-
tled while others are increasingly delayed. If liquidity is
reduced to 0 (point 4) no payment can be settled by gross
settlement.
Interest in intraday liquidity derives from developments in
paymentsystemsandshrinkingdeliverytimes.Paymentsys-
temsarecurrently inakindof interimstage.Earlier,before
the1990s,operationswerestrictlyonthedailylevelandintra-
day liquidity had no significance. As the processing of pay-
mentshasbeenspeededupandcentralbankshaveconverted
toRTGS,intradayliquidityhasreceivedincreasingemphasis.
As speed becomes more important, banks’ liquidity needs
increasetowardtheupperbound3.
If payments are queued, various netting and splitting algo-
rithmscanbeusedtoreduceliquidityneedsandspeedupthe
854 Figure3depictsathree-dimensionalcostminimizationproblemintermsofcredit
risks,liquidity,andpaymentdelaycosts.Allofthecostdimensionsinthechart
canbetradedoffagainsteachother.Therelationshipswithagiventechnology
areusuallyconvexresultinginauniquecostoptimum.
Figure3:Structuralcostsofpaymentandsettlementsystems
Settlement-delaycosts
Liquidity-usagecosts
Credit-riskcosts
System A
System B
simulation: A powerful research tool in payment and settlement systems
Bank of Finland simulatorTheBankofFinlandPaymentandSettlementSimulatorcan
be characterized as a deterministic system with decision-
makingcapability,whichtakesstochasticdataasinput.Fora
giveninputdataandchoiceofalgorithmsandparameters,the
simulatorwillalwaysproducethesameresults.Usuallytime
seriesovermanydaysareinputinordertogetagraspofthe
fluctuationrangesofthevariousresults.Onecancreateand
use algorithms with decision-making capability that enable
payments processing in accord with different settlement
modesandbehaviormodelsforsettlementparties(banks).
Thesimulatorisbuiltfor independentPCusageandiscom-
posed of three subsystems — input generation, simulation
execution,andoutputanalysis.
ThesimulatoroperateswithMicrosoftNT,XPand2000and
requirescentralmemoryofat least256MB.Ausers’guide
andorderandinstallationdirectionsareavailableatwww.bof.
fi/sc/bof-pss.DistributionishandledviaInternet.UsingJava,
theusercanbuildnewsettlementalgorithmsandlinkthemto
thegivenstructures.Thedatabaseisbasedonthecost-free
MySQLdatabase.
using the simulatorTheBankofFinlandSimulatorisamodernresearchtoolthat
has been well received, particularly by other central banks.
Currently,about20centralbanksaroundtheworldareusing
it. These include all the Nordic central banks, European
CentralBank,severalEuropeannationalcentralbanks,Bank
for International Settlements, Federal Reserve Bank of New
York, Bank of England, Bank of Canada, and several central
banks in Asia. The simulator is used inter alia for studying
liquiditypoliciesandcounterpartyandsystemicrisks,making
efficiency comparisons, and developing algorithms, pricing
policies, and settlement modes. The European Central Bank
hasbeenparticularlyhelpfulinadvisingondesignandintest-
ingthenewversionofthesimulator.
Payment and settlement systems have received relatively
littleattentionfromfinancialmarketresearchers.Thesolu-
tions have usually been based on conventions applied by
those in charge of actual payment system operations. A
modernautomatedpaymentsystemisbasedpurelyondata
transferlogisticsexceptforthefactthatevenasmallnum-
ber of bits may contain credit transfers worth billions of
monetaryunits.Onewouldhopeforanexpansionofresearch
inpaymentsystems.
TheBankofFinlandPaymentandSettlementSimulatorpro-
videsnewtypesofopportunitiesinthisarea.Interestingand
sparsely-studiedareasofresearchincludeDVP-basednetting
and queuing algorithms in securities settlement systems.
Relatedtopicsofspecialinterestmightbemodelsofpartici-
pantbehaviorinvariousstressandemergencysituationsand
theconsequencesforsettlementrisks.Variousriskmanage-
mentsystemsthatmaybeincorporatedinpaymentsystems
represents another area that could benefit from further
research(i.e.thereactionsofparticipantsandthesystemto
terroristattacksandtoparticipants’liquidityproblems).
Theintentionistodevelopandexpandthesimulatoronthe
basis of experience and user feedback. It is hoped that an
active group of users will share experiences and ideas for
86 - The Journal of financial transformation
Transition
European payment systems andmonetary union
Francisco J. callado muñozAssistant Professor, university of Girona
natalia utrero gonzálezVisiting Professor,
universitat Autonoma de Barcelona
Abstract
We make a comparative study of payment systems for E.U.
-fifteencountriesforthe1996-2002period.Specialattention
is paid to the introduction of the new European single cur-
rency.Theoveralltrendinpaymentsisforamovefromcash
tonon-cashpaymentinstruments,althoughelectronicinstru-
mentsarenotwidelyusedyet.We finda significant impact
fromtheintroductionofthenewbanknotesandcoinsoncard
use.
87
InaworldofeconomicglobalizationandITdevelopmentthe
waysinwhichpaymentsaremadeareclearlyevolving.Cash
isnolongertheuniquepossibilityofmakingapaymentandit
sharesthestagewithcreditanddebitcards,directdebits,and
electronicmeans.
Bankersandotherprofessionals1areveryinterestedinknow-
inghowcustomersarepayingfortheirdailytransactionsand
monitoringwhatchangesaretakingplace.Theyarenotalone,
financialauthoritiesarealso interested inthis typeof infor-
mation,sinceoneoftheirresponsibilitiesisthepromotionof
efficiencyandsecurityofbothpaymentsystemsand instru-
mentsinordertosafeguardthemonetarypolicytransmission
mechanismandtocontributetothemaintenanceofsystemic
stabilityandpublicconfidenceinthecurrency[ECB(2002)].
Thepurposeofthispaperistostudythemaintrendsinpay-
mentsystemsacrosstheE.U.-15countriesfortheperiod1996-
2002. The data used in our analysis are derived from the
EuropeanCentralbank(dataonpayments)andtheEuropean
commission (economicdata).Thisanalysis is interestingnot
only to have a portrait of the evolution of payment instru-
ments usage in a general setting2 but also to analyze the
impactoftheintroductionofthenewcurrency,bothamong
thefirst11countriesin19993andthefullintroductionofEuro
notesandcoinsin2002acrossE.U.-15,onthesesystems.
cash useToanalyze the importanceofcashpaymentsweuse twoof
thetypicalproxiesusedbytheBISstudies:cashincirculation
asapercentageofGDPandcashincirculationasapercent-
ageofnarrowmoney4.Figure1offersthesetwomeasuresfor
thecountriesincludedinthesample.Ascanbeseen,thereis
adeclineincashuseforbothindicatorsandforalmostevery
country.TheonlyexceptionistheU.K.,wherethereisaslight
increaseincashusagefortheperiod1996-2001inthepropor-
tionofnarrowmoneyandaround10%for1996-2002inthe
proportionoftheGDP.Withrespecttothedistinctionbetween
euroandnon-eurocountriesapointhastobemade.Theeuro-
zone shows a decrease for the period 1996-2001 and 1996-
2002,butitpresentsanincreaseincashusewiththeintro-
ductionofeurocoinsandnotesin2002,thatisaround35%.
Non-euro countries, on the contrary, decrease their use of
cashandthefiguresfor2002arequitesimilarto2001.
Itcan,therefore,beconcludedthattheusageofcashdeclined
duringtheperiodofstudy,withtheexceptionofthephysical
introduction of the euro in 2002 that made the euro area
moredependentoncash.The‘dualcirculationperiod’5ofthe
neweuronotesandcoinsandtheformernationalcurrencies
together with the flourishing of money from the unofficial
economycouldexplainthisbreakinthetendencyofcashuse
reductionofthepreviousyears.
Retail paymentsAnother way of looking at payments systems would be to
analyzethecompetitionamonginstrumentsatretaillevel.On
theonehand,ATMnetworksallowcustomerstohaveaccess
to cash closer to the point of sale. On the other, EFTPOS
instruments,suchasdebitcards,provideconsumerswithnon-
cashmeansofpaymentrightatthepointofsale.Figures2to
5helpunderstandingtheirevolutioninthelastyears.
1 Companiesdifferentfrombanks(namelyretailstores,insurance,petrolstations
etc.)arenowofferingpaymentservicestotheirclientsmainlytroughcreditand
debitcards.
2 MarkoseandLoke(2000)madeafirstattempttoanalyzepaymentusageforthe
period1990-1998andservedasastartingpointforthiswork.
3 TheintroductionofthesinglecurrencyinGreecetookplacein2001.
4 UsuallyrelatedtoM1,althoughthecorrespondenceisnotalwaysexact.
5 Thespeedofthechangeoverwasnotthesameinallcountries.Thedualcircula-
tionperiodlastedbetweenfourweeksandtwomonths.
European payment systems and monetary union
88
cash % of narrow money cash % of gdP
1996 2001 2002 1996 2001 2002
Belgium 27.5 11.8 - 5.1 2.8 -
Denmark 10.2 9.2 8.7 3 2.9 2.9
Germany 27.6 11.3 - 6.9 3.3 -
Greece 44.1 30.9 - 6.5 5.5 -
Spain 25 12 - 10.3 6.6 -
France 14 7.4 - 3.3 2 -
Ireland 34 16.5 - 4.7 3.3 -
Italy 16.1 11.3 - 5.3 4.7 -
Luxembourg 14.6 0.8 - 2.9 1.9 -
Netherlands 18 5.7 - 5.3 2.1 -
Austria 22.9 13.9 - 5.8 3.9 -
Portugal 15.3 8.7 - 4.9 3.6 -
Finland 6.6 6.1 - 2.2 1.9 -
Sweden - 4.1 4.5 4.1
U.K. 4.9 5 4.8 3 3.3 3.3
E.U. 13.8 8.6 11.5 5.3 3.5 3.5
Euro-zone 18.1 10.3 14.1 5.8 3.5 4.8
Figure1
European payment systems and monetary union
WhenlookingattherelativenetworkdensitiesofEFTPOSto
ATMterminalswefindthatthereisnoregularpatternacross
all countries. Greece, Italy, Austria, Sweden, and Portugal
seemtohaveanincreaseinthisperiodalthoughtherateof
growth differs across the countries. Germany, Ireland, and
Spaingrowatthebeginningoftheperiodandthendecrease
inthelateryears,whileFrance,Finland,andLuxembourgare
relativelyunchanged.Denmark,Belgium,andtheU.K.donot
showacleartendency.WithrespecttotheEuroandE.U.coun-
tries,bothgroups increaseatasimilarratealthough,again,
withtheintroductionofthenotesandcoins(2002)theeuro-
zonesuffersaslightdecrease.Thisfactfollowsthesamepat-
ternasthoseobservedinFigure1.
Comparingthepercapitaratioofvalueofcardtransactions
(bothcreditanddebit)tothepercapitavalueofATMrelated
use,wefindthatmorethanhalfofthecountrieshavearatio
greaterthan1,thatis,thevalueofcardtransactionsisbigger
thanthevalueofcash.RemarkablecasesarethoseofFrance
and Sweden that start the period below 1 and end up with
cardsovercashin2002.TheE.U.asawholepresentsalsoa
dominanceofcardinvalueterms.Thisdoesnotholdforthe
Euro-zone since the six countries in which cash is still the
mostimportantpaymentinstrumentarewithinthemonetary
union.Again,in2002,theratioindicatesariseincashusein
thiseuro-zone.
WithregardstotheintensityofcardandcashperEFTPOSand
ATM terminals in terms of value, although no general trend
canbeidentifiedintherelativeimportanceofeachthereisan
increaseintheintensityofcarduse,thatis,eachEFTPOSis
processingagreatervalueof transactions.Thisgrowthpat-
tern holds for almost every country, including the E.U. and
Euro-zonecountries.Interestingly,fortheEuro-zonecountries
thisincreasealsoholds2002.
The intensityofcashusebyATM,onthecontrary,doesnot
follow a clear tendency. Some countries grow, some others
decline, and some remain nearly constant and figures are
morestable inall cases.TheE.U.and theEuro-zoneexperi-
encerelativegrowthuntil2002,whentheincreasebecomes
moreprofound.
It can be concluded then that cards are being more inten-
sivelyusedthancash.Consequently,financialauthoritiesand
bankers could increasemore thanproportionally theaccep-
tanceanduseofcards,andintheprocessdecreasetheuseof
cash, just by increasing the relative number of EFTPOS to
ATMs.
cash and non-cash electronic paymentsWe also looked at the relationship between cash use (as a
percentage of narrow money) and non-cash electronic pay-
ments and their evolution from 1996 to 2002 across these
countries (Figure 2). We found that at the beginning of the
periodalmosteverycountryhadahighcashuseandamore
variableelectroniccomponent.By2002,mostcountrieshad
lowerusageofcashandincreasedtheproportionofnon-cash
electronicpayments.OnlyIrelandremainswithahighdegree
ofcashusage,howevergiven itsstartingpointofveryhigh
cashuseandlowusageofnon-cashelectronicpayments its
89
110
100
90
80
70
60
50
40
30
110
100
90
80
70
60
50
40
30
0 10 20 30 40
Highusageofelectronicpayments
Highusageofcash
Ir
Ir
P
P
Fi
Fi
UK
UK
Fr
Fr
It
EU
EUIt
e
e
S
S
B
B
G
GA
A
D
D
Figure2:Cashuseandnon-cashelectronicpayments
6 Irelandisthecountrywherechequeshavethemostrelevantusebothinvolume
andvalue,butwefindthatitsimportancealsofallsduringthisperiod.
7 ItisimportanttoremarkthatATMandEFTPOSterminalsincrease54%and86%
respectivelyintheE.U.duringtheperiod(computedfromEurostatfigures).
European payment systems and monetary union
triesandsuggestthatfinancialstructure,aswellastheintro-
ductionofthesinglecurrency,mayhaveaffectedthedecision
to use them. In this section, we want to investigate more
deeplytheempiricalevidenceontheserelationships. Inpar-
ticular,wetestthreehypotheses:
■ Whetherthefacilitiesdevelopedbyfinancialinstitutions
significantlyinfluencetheuseofcardsinstruments?
■ Ifthedegreeofeconomicdevelopmentcanalsoaffect
carduse?
■ Whethertheintroductionofnewcoinsandbanknotes
influencetheevidencedincreasingtrendincarduse?
Specifically,wedistinguishbetweentheuseofcardstowith-
drawmoneyfrombankaccountsandtheuseofcardsaspay-
ment instrumentatpointofsale.Weestimate the following
equations:
Card usei,t = α + β * banking industry facilitiesi,t + γ*gdpi,t
+ψt+εi,t (1)
wherei=1,…,nreferstocountriesandt=1,…,Ttotimeperiods.
Fromaneconometricpointofview,fortheestimationofthe
coefficientsα,β,andγwetakeintoaccountthestructureof
theerrorterms,εit8.Wealsoallowforthepresenceofunob-
servableindividualeffects9.
Thevariables thataccount for thebanking facilitiesare the
number of branches and the number of ATM and EFTPOS
available.Allvariablesarecontrolledforthepopulationofthe
countryinordertoallowcomparisons.Thenumberofbranch-
esisincludedinallregressions.However,weusethenumber
of ATMs when the dependent variable is the use of card to
withdrawmoneyandthenumberofEFTPOSinsteadwhenthe
dependent variable is the payment function of credit/debit
cards.Thenumberofbranchesaccountsfortheproximityof
thebankinginstitutiontocustomers.Theexpectedsignofthis
variableintheuseofcardsisnotobviousexante.Ontheone
hand,closeservicetocustomermightreducecardusebothto
withdrawmoneyandtopay,suchthatcustomershaveaccess
toadirectandpersonalserviceeasily(substituteeffect).On
theother,thecloserserviceassociatedtoalargernumberof
branchescantransmittrustandreliabilityinthebankinginsti-
tutionandfostertheuseofcards(reliabilityeffect).Wewilltry
toshedsomelightastowhicheffectisstronger.
Thephysicalfacilities,namelynumberofATMsandthenum-
berofEFTPOSpositivelyinfluencetheuseofcards.Thelarger
numberofATMs(EFTPOS)thelargertheprobabilityofusing
them.Therefore,theexpectedsignispositive.
To capture the effect of the introduction of the euro, we
includetwodifferentdummyvariables,onefortheyear1999
whentheEuropeansinglecurrencywas introducedandone
fortheyear2002whenthebanknotesandcoinswerephysi-
callyintroduced.Finally,weincludethepercapitaGDPineach
countrytocontrolforthedegreeofeconomicdevelopment.
The expected sign is positive. The use of cards requires a
minimumdegreeofelectronicfacilitiesandcommunications
tooperatecorrectly.Weassumethateconomicdevelopment
isagoodproxyfortechnologicaldevelopment.
Figure3presentstheresultsforthewithdrawalfunctionsof
cards. We estimate the equation using three different mea-
sures of the dependent variable. The cash use of cards is
computedintermsofthetotalvolumeoftransactions,num-
beroftransactionsdone,andtheaveragevaluepertransac-
tioninPanelsA,B,andCrespectively.
ATMnetwork influencessignificantlyandpositivelycarduse
towithdrawmoneybothintermsofvolumeandthenumber
oftransactions,as itcanbeobserved inall runs inPanelsA
and B. However, the average value of transactions is not
affected by ATM network (panel C). Column 1 in each panel
presentstheresultswhenthedummyvariablethataccounts
fortheintroductionofthesinglecurrencyisintroduced.The
1999variableisnotsignificantinanyoftherealizations,that
is in volume, number of transactions, or average value.
However, thedummy for the introductionof thebanknotes
90 - The Journal of financial transformation
European payment systems and monetary union
development isoneof themost remarkableofanycountry.
WedonotfindacleardistinctionbetweentheE.U.andEuro-
zonecountries.Althoughtheoriginisdifferent,lesscashuse
inE.U. countries, theybothendup inaprettymuchsimilar
positionby2002.Therefore,intermsofvolume,wefindthat
thereisacleartrendtowardslowercashusageandtogreater
usageofnon-cashelectronicmeansofpayment.
Evolution of non-cash payment instrumentsAsshowninFigure2,thereisatrendfromcashtonon-cash
paymentinstruments,althoughpaper-basedinstrumentsare
stillimportantinmanyE.U.countries.Whatweintendtodoin
thissection is toassess therelative importanceof thenon-
cashpaymentinstrumentsinvolumeandvaluebetween1996
and2002.
We find that the use of cheques decrease significantly
between these two periods6. The use of credit and debit
cardsincreaseconsiderablyduringthisperiod,althoughtheir
relativeimportanceintermsofvalueissmall.Hence,itseems
thatcarduse isprobablymorerelatedtodailyoperations7.
Credittransfersaccountforthemajorityoftotalvaluetrans-
actionsandareimportantintermsofvolumeoftransactions,
although it falls during the period. Direct debits, instead,
remainfairlystableinallcountries.
Althoughonewouldexpectthatelectronicinstrumentswould
experience a significant increase in popularity during this
period,wefindtheirusageremainsquitesmall,particularlyin
valueterms.Belgium,Luxembourg,andTheNetherlandsare
the countries with highest usage of electronic instruments
andexperiencethelargestincrease.Thislackofgrowthtakes
place at a time when access to new technologies and the
Internet has experienced a huge increase in E.U. countries
(876%intheperiod1996-2001accordingtoEurostatfigures).
It seems logical, therefore, that should financial institutions
wishtoincreasetheusageofelectronicmoneyacrossEurope,
theywouldneedtoinvestheavilyinbettersecuritysystems,
transparency,andpublicityinordertoincreaseconsumerreli-
abilityandthesuccessofthesepaymentinstruments.
We also examined the potential impact of the euro on the
usageofnon-cashelectronicpaymentsand instruments,by
lookingatthechangesintheyears1998-1999and2001-2002,
andfoundno‘euroeffect’.Wefoundthattherewasnobreak
in tendency present. On the contrary, results confirm the
trendsandpatterns found in thewholeperiod, inparticular
relativetothevalueoftransactions.Therefore,theintroduc-
tion of the new bank notes and coins do not seem to have
dramatically impacted the relative importance of non-cash
instruments.
Econometric analysisTheprevioussectionsshowthatboththerelativeimportance
of cash and non-cash use and the distribution of non-cash
instrumentsarenothomogeneousacrosstheEuropeancoun-
918 Theerrorterm,εi,j,t isidenticallydistributedanduncorrelatedacrossobserva-
tionsandwithexogenousvariables,butcov(εi,j,t,εi,j,s)maybedifferentfromzero
ift=s.
9 Individualeffectscanbetreatedasfixedorrandom.Theproblemisnotifeffects
arefixedorrandom.Theproblemiswhethertheeffectsarecorrelatedtothe
observablevariables.Whencorrelationispresent,conditionalinferencemustbe
done(fixedeffectestimation)[ArellanoandBover(1990)].TheHausmantest
showthatindividualfixedeffectsarenotcorrelatedwiththeexplicativevariables,
thereforetherandomeffectestimatorisconsistent.However,insomespecifica-
tionstheHausmantestrejectsthehypothesisthattherandomeffectestimatoris
consistent,thereforefixedeffectestimationisused.
Panel A: Total volume of transactions
Thedependentvariable,Cashvalue,isthetotalvolumeofcardtransactionsto
withdrawmoney.FinancialfacilitiesarenumberofATMs(NºATMs)andnumberof
branchoffices(branch)per1000inhabitants.D1999andD2002accountforthe
yearofintroductionofthecommoncurrencyandnotesandcoinsrespectively.
(1) (2) (3) (4)
cash value cash value cash value cash value
Nº ATMs 2679939c 2748867.65c 2779121.05c 1236233.59c
x 1000 inhab [428515] [438,145.177] [436,816.852] [431,538.405]
D1999 -63003.57
[132541.4]
D2002 512,332.699c 543,062.722c 443,695.083c
[133,264.997] [134,744.668] [119,858.977]
Branch 734,546.0198 1788831.82c
x 1000 inhab [562,480.867] [499,017.945]
Per Capita GDP 96,257.126c
[15,444.7848]
Constant 694017.1b 575,140.862b 207,085.4122 -1.6117e+06c
[314588.3] [235,788.986] [366,794.189] [443,397.185]
Obs 95 95 95 90
R-squared 0.4872 0.57 0.58 0.69
Hausman test 0.00 187.85c 32.92c 125.59c
Standarderrorsinbrackets
a—significantat10%;b—significantat5%;c—significantat1%
Figure3:Useofcardstowithdrawmoney
European payment systems and monetary union
andcoinsispositiveandsignificant,inparticularintotalvol-
umeandtheaveragevalueoftransactions.Therefore,itcan
be claimed that although the changeover to the euro took
place in 1999, it is the introduction of notes and coins that
enhances theuseofcardsatATMs.Hence, the ‘euroeffect’
takesplacein2002.
Whatismostinterestingisthattransactionsdonotincrease
butthevalueofeachtransactionishigher.Onepossibleexpla-
nationcouldbethevalueoftheeurobanknotes;largerthan
the national ones. Moreover, perhaps the increase in prices
duetotheroundingmighthaveaffectedthisresultaswell.As
thedummy1999isnotsignificant,weintroducethedummy
correspondingto2002fortherestoftherealizations.
The degree of economic development affects positively the
cashuseofcards,independentofthetypeofmeasureintro-
duced (Column 4). Hence, the more developed the country,
themoreuseofcashinstruments.Theeffectsofthebranch
networkarenotconclusive.Whenitisintroducedalonewith
the2002timevariable(Column3), itscoefficient isnotsig-
nificant.However,whenitisincludedwiththedegreeofeco-
nomicdevelopment, itscoefficient ispositiveandsignificant
(Column4).Inthiscase,the‘reliabilityeffect’overcomesthe
substitutiveeffectoflargerbranchnetwork.Thefactthatthe
branchnetwork isonly significant jointlywith theeconomic
development may mean that the ‘reliability effect’ is taken
into account by consumers in economically developed envi-
ronments.
Figure4presentstheresultsfortheuseofcardsasapayment
instrument.Again,wemeasure theuseofcards in termsof
total volume, number of transactions, and average value of
transactionsinPanelsA,B,andCrespectively.Inthiscase,we
replacethenumberofATMswiththenumberofEFTPOSavail-
able. The EFTPOS network influences significantly and posi-
tivelycardusetopaybothintermsofvolumeandthenumber
of transactions (Panels A and B of Figure 4). However, the
averagevalueoftransactionsisnotaffectedbytheEFTPOS
network(PanelC).
92 - The Journal of financial transformation
Panel B: number of transactions
(1) (2) (3) (4)
transactions transactions transactions transactions
x 1000 inhab x 1000 inhab x 1000 inhab x 1000 inhab
Nº ATMs 24005.42c 21598.94c 21423.62c 14271.28c
x 1000 inhab [2460.575] [2858.337] [2897.677] [2998.799]
D1999 78.20867
[705.4583]
D2002 1271.141 1375.165 883.5491
[853.0511] [887.9476] [826.8769]
Branches 1537.869 8420.163c
x 1000 inhab [3637.473] [3418.001]
Per Capita GDP 513.3503c
[104.8599]
Constant 9254.231c 10414.3c 9771.093c -1007.743
[3284.545] [3071.285] [3472.797] [4014.939]
Obs 96 96 96 91
R-squared 0.58 0.59 0.60 0.70
Hausman test 0.000 0.000 0.000 0.000
Panel c: Average value of transactions
Thedependentvariable,transact(respectivelyAtmvaptr),isthenumberofcard
transactionstowithdrawmoneyper1000inhabitants(theaveragevalueofeach
transactioninPanelC).
(1) (2) (3) (4)
Atmvaptr Atmvaptr Atmvaptr Atmvaptr
Nº ATMs 47.3895c 21.73221b 21.1738b 1.984646
x 1000 hab [10.82327] [11.149] [11.252] [12.9219]
D1999 .22863
[3.1227]
D2002 16.36994c 16.91159c 14.5724c
[3.4754] [3.587] [3.8473]
branch 9.372596 22.6672
x 1000 hab [14.008] [14.5687]
Per Capita GDP 1.28423c
[0.4399]
Constant 80.5646c 92.616c 88.4251c 64.1529c
[11.9013] [10.6675] [12.301] [14.794]
Observations 95 95 95 90
R-squared 0.21 0.38 0.38 0.42
Hausman tests 2.42 4.24 0.16 3.97
Standarderrorsinbrackets
a—significantat10%;b—significantat5%;c—significantat1%
Figure3(continued):Useofcardstowithdrawmoney
European payment systems and monetary union
93
Panel A: Total volume of transactions
Thedependentvariable,Cardvalue(transactrespectivelyinpanelB),isthetotalvol-
umeofcardtransactionstopay(numberoftransactionsper1000inhabitantsin
panelB).FinancialfacilitiesarenumberofEFTPOS(NºEFTPOS)andnumberof
branchoffices(branch)per1000inhabitants.
(1) (2) (3) (4)
card value card value card value card value
Nº EFTPOS 156,810.932c 121,445.9548c 123,352.5818c 78,832.6894c
x 1000 inhab [15,586.6287] [17,011.3802] [16,356.7001] [20,965.4774]
D1999 -42,835.8330
[109,146.4338]
D2002 458,201.2561c 400,076.4758c 382,155.4983c
[115,378.6766] [112,836.9966] [110,798.7588]
Branch -1.3803e+06c -977463.0924b
x 1000 inhab [428,152.4659] [410,066.2826]
Per Capita GDP 49,812.2575c
[15,261.9106]
Constant -243328.4348 32,956.2763 683,449.0571b -220039.2793
[276,408.5673] [278,312.3132] [324,643.9854] [404,918.4418]
Obs 105 105 105 100
Number of cntry 15 15 15 15
R-sqd 0.24 0.27 0.40 0.53
Hausman test 2.60 1.54 0.03 5.84
Panel B: number of transactions
(1) (2) (3) (4)
nº trans nº trans nº trans nº trans
x 1000 inhab x 1000 inhab x 1000 inhab x 1000 inhab
Nº EFTPOS 3,056.3032c 2,389.7544c 2,409.6415c 1,779.6621c
x 1000 inhab [300.3363] [330.6613] [328.3495] [468.6010]
d1999 -763.6574
[2,085.3649]
d2002 8,449.3579c 7,673.1950c 7,855.6110c
[2,226.9987] [2,251.3461] [2,376.2326]
Branch -18,881.4428b -11,658.9786
x 1000 inhab [8,683.1587] [9,080.0094]
Per Capita GDP 726.5331b
[348.2890]
Constant -3,146.8811 2,095.4014 11,055.6887 -2,927.7474
[5,903.6937] [5,955.6091] [6,824.2131] [9,377.8244]
Observations 101 101 101 96
R-squared 0.23 0.25 0.39 0.40
Hausman Test 1.86 1.19 0.06 4.53
Panel c: Average value of transactions
Thedependentvariable,posvaptr,istheaveragevalueofcardtransactionstopay.
FinancialfacilitiesarenumberofEFTPOS(NºEFTPOS)andnumberofbranchoffices
(branch)per1000inhabitants.
(1) (2) (3) (4)
Posvaptr Posvaptr posvaptr Posvaptr
Nº EFTPOS 0.0601 -0.1498 -0.1514 -0.7356b
x 1000 inhab [0.1939] [0.2267] [0.2242] [0.2949]
D1999 -0.6359
[1.3386]
D2002 2.6534a 3.0135b 1.7008
[1.5227] [1.5222] [1.4256]
Branch 9.7409 16.9185c
x 1000 inhab [6.0324] [5.6443]
Per Capita GDP 0.7928c
[0.2243]
Constant 53.7210c 55.3227c 50.6277c 34.9544c
[4.2114] [4.2955] [5.2119] [6.3063]
Observations 105 105 105 100
R-squared 0.01 0.02 0.04 0.27
HausmanTest 0.70 0.28 4.63 3.78
Standarderrorsinbrackets
a—significantat10%;b—significantat5%;c—significantat1%
Figure4:Useofcardstopay
European payment systems and monetary union
As in Figure 3, Column 1 in each panel presents the results
whenthe1999dummyisintroduced.The1999variableisnot
significant in any of the realizations. However, the 2002
dummy,whichaccountsfortheintroductionofthebanknotes
and coins, is positive and significant. Therefore, it can be
claimedthatthereisaeuroeffectthatalsoenhancestheuse
of cards as payment instrument. A possible interpretation
couldbethatconsumersprefertousecardstopayduetolack
ofknowledgeandconfidenceinthenewbanknotes.
ContrarytoATMsuse,thenumberofEFTPOStransactionsdo
increase significantly in 2002, although the value of each
transaction isnotalteredsignificantly.This result reinforces
thehypothesisthattheincrementalincreaseinvalueofATM
transactions is causedby the largernewbanknotes, rather
thantheincreaseinpricesaftertheintroductionofthesingle
currency.Ifthelatterwasthecauseitwouldalsohaveimpact-
edthevalueofEFTPOSoperations.
Branchnetworkhasasignificantlynegativeimpactonuseof
cardsforpayment,intermsofvolumeandnumberoftransac-
tions. Therefore, in the case of EFTPOS, it seems that the
substituteeffectisdominant.Resultsfortheaveragevalueof
transactions, however, are not conclusive. When the branch
variable is introducedalonewiththe2002timevariable, its
coefficientisnotsignificant(PanelC);but,whenitisincluded
with the degree of economic development, its coefficient is
positiveandsignificant.Inthiscase,thereliabilityeffectover-
comes the substitutive effect of larger branch network.
Therefore,thetrustinthefinancialsectorisimportantforthe
increaseinthevalueofcardoperations.
Finally, we introduce the degree of economic development.
Thecoefficientispositiveandsignificantinallthreecases,as
expected.Hence,themoreeconomicallydeveloped,themore
useandtrustincards,bothtowithdrawandtopay.
conclusionThispaper illustratesthattheuseofcashdeclinedbetween
1996and2002.Therewasanincreaseinnon-cashpayment
instrumentsduetonewtechnologies, inparticularcarduse.
Accordingly, traditional instruments such as checks experi-
enceadecline,butsurprisinglyelectronicmoneyrelevanceis
still very small. The econometric estimations confirm the
descriptiveanalysisresultsconcerningcashuse.Furthermore,
thereisevidencethattheintroductionoftheeurobanknotes
andcoinsenhancescardusesignificantly,bothatATMsand
EFTPOS.Economicdevelopmentandfinancialsystemsfacili-
tiesaffectcarduseaswell.Hence,reliability inthefinancial
system is crucial for the use of cash less instruments.
Therefore, should financial institutions want to support the
useofthesepaymentinstrumentstheywouldneedtoinvest
insecuritysystems,transparency,andpublicity.
References• Arellano,M.andO.Bover,1990,“Laeconometríadedatosdepanel”,
InvestigacionesEconómicas(SegundaÉpoca),14(1),3-45.
• Eurostat.2004.“Economicdata”.EuropeanCommission.http://epp.eurostat.cec.
eu.int/portal/page?_pageid=1090,1137397&_dad=
portal&_schema=PORTAL
• Greene,W.H.,1998,Análisiseconométrico.Terceraedición,(Prenticemay-Madrid).
• MarkoseS.M.andY.J.Loke,2000.“Changingtrendsinpaymentsystemsfor
selectedG10countriesandE.U.countries1990-1998”.InternationalCorrespondent
BankingReview,Yearbook,2000/2001,EuromoneyPublication
• EuropeanCentralBank,2004.“BlueBook,Paymentandsecuritiessettlementsys-
temsintheEuropeanUnion,Addendumincorporating2002figures”.April
• EuropeanCentralBank,2002.“E-paymentsinEuropetheEurosystem’s
Perspective”.September
• BankforInternationalSettlements,2004,“Statisticsonpaymentandsettlement
systemsinselectedcountries,figuresfor2002,”CommitteeonPaymentand
SettlementSystems,March
94 - The Journal of financial transformation
Transition
Technological innovation in retail payments: Key developments and implications for banks1Karen Furst
Policy Analyst, Office of the Comptroller of the Currency
daniel E. nolleSenior Financial Economist,
Office of the Comptroller of the Currency
Abstract
TheUnitedStates still hasaheavilypaper-based retailpay-
ment system when compared with many other developed
economies,buttheshifttoelectronicpaymentshasbeenbig-
gerandmoredecisivethancommonlyperceived.Forthefirst
time ever, check use declined in the mid-1990s, and among
electronicpaymentstheadoptionofdebitcardshasoccurred
atanextremelyrapidpace.Thepurposeof thisarticle is to
promotegreaterawarenessofthenatureofrecentchangesin
retailpaymentsintheUnitedStates,andtoexploresomeof
thekeyimplicationsofthosechangesforthebankingindus-
try.Wedescriberecenttrendsinretailpayments,highlighting
thesurprisingdropincheckusage,andconsidertheimpactof
changes in retail payments on bank revenue and costs. We
concludethat,althoughbanksarelikelytorealizesubstantial
long-runpayments-relatedimprovementsinproductivity,they
facegreater-than-commonly-appreciatednear-termchalleng-
es.
951 Theopinionsexpressedinthisarticlearethoseoftheauthorsalone,anddonot
necessarilyrepresentthoseoftheOfficeoftheComptrolleroftheCurrencyorthe
U.S.TreasuryDepartment.TheauthorswouldliketothankDavidNebhut,Mark
Levonian,andJeffreyBrownforhelpfulcomments.
Technological innovation in retail payments: Key developments and implications for banks
Recent changes in the retail payment landscapeTheUnitedStateshas longbeenconsideredunusualamong
developed economies for its reliance on paper checks, and
henceforitsproportionatelyloweruseofelectronicmeansof
payments.4 The annual publication by the Bank for Interna-
tionalSettlements(BIS)ofpaymentsystemstatisticsforthe
G-10 countries in its ‘Red Book,’ considered to be the most
authoritativesourceforsuchinformation,ratifiedthepercep-
tionofcontinuing,thoughslowing,growthofcheckusagein
theUnitedStates.5Onthebasisofsuchinformation,payment
system officials, practitioners, and analysts commonly
observedthat,althoughU.S.consumersandbusinesseswere
steadily increasing theuseofelectronicmeansofpayment,
theyneverthelesscontinuedtoclingtocheckusage.
Itwasthereforeatremendoussurprisewhen,in2001,theFed
announcedtheresultsof itssurveyof theuseofretailpay-
mentsin2000[GerdesandWalton(2002)].Inparticular,data
onchecksshowedthatcomparedtoprevioussurveyresults
for1995,checkusagewaslowerforthefirsttimeever.Insub-
sequent annual editions of the BIS ‘Red Book’ on payment
statistics, the Fed restated its estimates of check usage for
pre-surveyyears.6AsFigure1illustrates,thoserestatements
show not only a declining trend in check usage, but lower
annualtotalsforeachyear.Fromthisitisclearthatboththe
magnitudeofconsumerandbusinessrelianceonchecks,and
thetrendinthatreliance,hadbeenoffbyafactorof25per-
centormore.
Theimprovementintheaccuracyofthecheckusagedatahas
directimplicationsforourviewofelectronicpayments.These
areclearlyillustratedinFigures2and3,whichfocusonthe
pre-2000period.Figure2showsthattherewasagreaterreli-
anceonelectronicpayments thanhadbeenpreviouslysup-
posed.Inparticular,whereastheold(withoriginalcheckdata)
perceptionwasthatinthelate1990ssomewhatmorethana
quarterofallnon-cashretailpaymentswereundertakenwith
an electronic medium, the true figure (with revised check
data)wascloserto40percent.Figure3illustratesthatforthe
first time ever, electronic payments actually exceeded pay-
mentsbycheckbeginning in2002. In thatyear,42.3billion
consumerandbusinesspaymentswereconductedviacredit
cards, debit cards, or the ACH (automated clearing house)
system,comparedwith40billionpaymentsviacheck.Clearly,
consumers and businesses have decisively shifted payment
patternstowardelectronicmedia.
96
1991e 1992e 1993e 1994e 1995 1996e 1997 1998 1999
Original data 57.47 58.40 60.30 61.67 62.92 64.68 66.09 67.00 68.00
Revised data 43.50 44.63 45.79 46.98 49.5 48.15 46.57 45.17 43.81
Figure1.ChangingperceptionofcheckusageintheU.S.(billionsoftransactions)
Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears).
Note:1996‘reviseddata’isanestimateconsistentwithrevisionsmadetoRedBookdatafor1997-2000bytheBIS.1991-1994‘reviseddata’areestimatesbasedontheaverageannual
rateofcheckusegrowthbetween1979and1995,asperGerdesandWalton(2002).
1991e 1992e 1993e 1994e 1995 1996e 1997 1998 1999
With original check data 18.64 19.87 20.75 22.30 24.11 25.94 24.43 26.76 29.33
With revised check data 23.24 24.49 25.63 27.37 28.78 32.06 31.45 35.15 39.18
Figure2:Changingperceptionofimportanceofelectronicpayments:Electronicpaymenttransactionsasapercentofallnon-cashpayments
Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears).
Note:1996‘reviseddata’isanestimateconsistentwithrevisionsmadetoRedBookdatafor1997-2000bytheBIS.1991-1994‘reviseddata’areestimatesbasedontheaverage
annualrateofcheckusegrowthbetween1979and1995,asperGerdesandWalton(2002).
2 Analystsandpractitionersdividepaymentsintowholesaleandretailpayments.
Wholesalepaymentsconsistofverylarge-valuepayments,especiallyinter-bank
paymentsrelatedtobanks’clearingandsettlementrole.Retailpaymentsinclude
consumer-to-businessandbusiness-to-businesspayments.Themajorcomponents
ofretailpaymentsintheUnitedStatesincludecash,checks,creditcards,debit
cards,andautomatedclearinghouse(ACH)transactions.Unliketheotherformsof
retailpayments,reliablerecordsforthenumberandvalueofcashpaymentsare
notmaintained,andhenceexactdataoncashusageisimpossibletoobtain(and
evenestimatesaregenerallyconcededtobeoftheballparkvariety).Forthisrea-
son,mostanalysesofretailpaymentsfocusonnon-cashpayments,aconvention
wefollowinthisarticle.
3 We,andmostothers,refertotheFederalReserve’s(2002)RetailPayments
ResearchProjectasasinglestudy,althoughitisinfactaseriesofthreeclosely
relatedstudiesconductedbytheFedinconjunctionwithseveralconsultingfirms.
Thecomponentstudiesarethe‘DepositoryFinancialInstitutionCheckStudy,’the
‘CheckSampleStudy,’andthe‘ElectronicPaymentInstrumentsStudy.’Gerdesand
Walton(2002)isconsideredanauthoritativesourceforadescriptionandanalysis
oftheretailpaymentsstudy.
Technological innovation in retail payments: Key developments and implications for banks
97
4 Unlessotherwisespecifiedinthisarticle,theterms‘electronicmeansofpayment’
and‘electronicpayments’refertocreditcard,debitcard,andACHpayments.Our
comparisonsofmeansofpaymentsfocusonthenumberoftransactions,rather
thanthedollar-valueoftransactions.Forinternationalcomparisonsofpayment
systemsseeHancockandHumphrey(1998).
5 Statisticsonpaymentandsettlementsystemsinselectedcountries,Bankfor
InternationalSettlements.Thesourceforeachcountry’sdataisitscentralbank,
whichofcourseistheFederalReserveinthecaseoftheUnitedStates.Itisimpor-
tanttounderstandthatincompilingannualpaymentstatisticstheFedusesvari-
ousestimationtechniques,andreliesonthird-partysourcesinsomeinstances,
becauseitisinfeasibletogetanactualcountofallnon-cashpaymentstransac-
tions,andimpossibletogetanactualcountofallcashtransactions.Notethata
thoroughsurvey,suchastheFedundertookfor1979,1995,and2000,entails
expensesthatfewwouldarguearejustifiedonanannualbasis.
6 TherevisionsintheRedBookincludeddatafrom1997-2000.Toarriveatarevised
figurefor1996,weappliedthesame3percentperyearestimateddeclineincheck
usetheFedusedtore-statethe1997-2000figures.GerdesandWalton(2002)
estimatedthat,onaverage,checkusegrewata2.6percentannualratebetween
1979and1995,amethodweusedtogeneraterevisedcheckusefiguresfor1991-
1994.
Thestunningadvancementsintelecommunicationsandinfor-
mation management in the early-to-mid-1990s profoundly
affectedthefinancialservicesindustry.Newproducts,suchas
credit derivatives were developed, access to credit was sig-
nificantly increased as a result of major improvements in
creditscoringandthedevelopmentofsecuritization,andnew
methods of delivering financial services, especially via the
Internet,emerged.Oneaspectoffinancialservicesprovision
that had, prior to this period, remained below most radar
screenswasretailpayments.2However,beginningintheear-
ly-to-mid-1990s,agrowingnumberofpractitioners,analysts,
andpolicymakersbegantofocusontheimportanceofretail
paymentsonfinancialintermediaries’performance,competi-
tive position, and relationships with third-party payments
servicesvendors.
A key feature of the retail payments landscape is the long-
termshiftawayfrompapertoelectronicmeansofpayments.
Recently, a comprehensive study of retail payments in the
UnitedStateswaspublishedbytheFederalReserveSystem.3
The study revealed a startling, and hitherto unrealized
change:whereasithadbeencommonlyperceived,andannu-
ally reported by the Fed, that check use continued to grow
throughoutthe1990s(albeitataprogressivelyslowerrate),
thenewstudyshowedthatforthefirsttimeever,checkusage
actuallydeclined in themid-1990s.Anecessarycorollary to
thisdevelopmentisthattheshifttoelectronicpaymentswas
moredramaticthanmanyhadimagined.
Theseprofoundchangesinretailpaymentstrendsarelikely
tohavemajor implications for financial intermediaries,par-
ticularly for banks, which are at the heart of the payment
system. The purpose of this article is to promote greater
awarenessofthenatureofrecentchangesinretailpayments
intheUnitedStates,andtoexploresomeofthekeyimplica-
tions of those changes for the banking industry. The next
sectiondescribesrecenttrendsinretailpayments,highlight-
ingthesurprisingdropincheckusage,followedbyanexami-
nationof the implicationsofchanges in retailpaymentson
bank revenue and costs, which concludes that, although
banks are likely to realize substantial long-run payments-
relatedimprovementsinproductivity,theyfacegreater-than-
commonly-appreciated near-term challenges. The final sec-
tionsummarizesandraisesanumberofpaymentsissuesthat
warrant further consideration by bankers and financial sys-
temregulators.
1995 1996e 1997 1998 1999 2000 2001 2002 2003e
Electronic 20.0 22.7 21.4 24.5 28.2 32.7 37.6 42.3 50.7
Check 49.5 48.0 46.6 45.2 43.8 42.5 41.2 40.0 38.0
Figure3.Electronicpaymentsovertakechecks(billionsoftransactions)
Source:OCCusingdatafromStatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears);NACHA;
CardIndustryDirectory2004;andMinehan(2004).
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003e
Credit card 4,7 5 5,6 6,6 9,1 10,4 11,5 12,6 14,2 16,9 18,4 19,7 21,1
Debit card 0,22 0,289 0,71 1,1 1,44 2,3 3,54 4,9 6,49 8,4 10,33 13,22 18,27
ACH 1,71 2,49 2,6 2,93 3,49 4,05 4,55 5,33 6,12 6,94 8,06 88,83 10,02
ATM 6,4 7,21 7,7 8,45 9,7 10,68 10,98 11,16 10,9 12,84 13,58 13,97 14,27
Figure4.Growthofelectronicpayments(billionsoftransactions)
Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears);NACHA;Card
IndustryDirectory2004;andEFTDataBook–2004Edition.
7 Onthebankingindustry’slong-termprospectsforrealizingnetbenefitsfrominno-
vationsinretailpaymentssee,forexample,Minehan(2004).
Technological innovation in retail payments: Key developments and implications for banks
siderable source of revenue. In particular, Radecki (1999)
found thatpaymentsconstitutebetweenone-thirdand two-
fifthsofoperatingrevenueforthetwenty-fivelargestbanking
companies. Furthermore, for banks of all sizes, payment
activities are central to deposit taking and lending relation-
ships.
A largecomponentofpayment revenuederives fromcheck
processing and checking account-related activities. Such
income streams include revenue from cash management
services,suchasprocessingcheckpaymentsatthelockbox,
interestincomefromdepositaccountbalances,andfeesasso-
ciated with insufficient funds.8 Declining check use means
thisrevenueisshrinkingandwillcontinuetoshrink.
Inadditiontothedeclineincheck-relatedrevenue,thereare
severalotherpayments-relatedforces likelytohaveanega-
tive impactonpaymentsrevenueforbanks.Firstly,manyof
the electronic payments replacing paper checks are lower
margin activities for banks. A recent Ernst & Young report
rather gloomily concluded that ‘although many banks have
spentyearsthinkingaboutandplanningforadeclineinpaper
payments,therealizationofthisphenomenonwasstillpain-
ful…Decliningpapervolumeswereseenfor[corporate]con-
trolled disbursements, as well as in check clearing, account
reconciliation,andinbothretailandwholesalelockbox.While
intheorythereshouldbeanupsideforproductssuchasACH,
EDI, and purchasing cards, the revenue declines seen from
paper products are not being offset by the replacing elec-
tronicalternatives’[Ernst&Young(2003,p.4)].Evenamong
electronic payments, banks are seeing slower growth for
thoseformsofpayments,suchascreditcards,withrelatively
higher margins, compared to other forms of electronic pay-
ments,suchasonlinedebit.9
Secondly,recentchangesinfeestructuresforelectronicpay-
mentshavehadanegativeimpactonpaymentsrevenuefor
manybanks.Animportantexampleisthe2003dropininter-
change fees on signature debit card payments (using Visa
checkcardordebitMasterCard),adeclinethatcameaboutas
aresultofshiftingmarketforces.10Themainparticipantsin
the market for signature debit card (and credit card) pay-
mentsarethemerchantsreceivingthepayments;merchant
acquirers,whicharefirms,includingsomebanks,thatbuyor
acquiredebitandcreditcardreceiptsfrommerchants,card-
issuingbanks,andthe twomaincardassociations,Visaand
MasterCard. Merchants sell their card receipts to merchant
acquirersatadiscounttofacevalue.Thesizeofthisdiscount
is largely based on the interchange fee merchant acquirers
mustpaytocard-issuingbankstocompletetheprocessingof
the card payments. In turn, the two card associations are
instrumental in determining interchange fees. A series of
recent events brought about a shift in the relative market
powerofthesemarketparticipants,resultinginasubstantial
decline in some interchange fees earned by card-issuing
98 - The Journal of financial transformation
1991 1995 1999 2003e
ATM 49.12 40.84 28.89 22.42
ACH 13.09 14.71 16.22 15.73
Debit cards 1.71 6.08 17.22 28.70
Credit cards 36.08 38.36 37.67 33.14
Figure6:Electronicpayments:Shifttodebitcardusage(percentoftotalelectronic
paymentstransactions)
Source:OCCusingdatafromNACHA;CardIndustryDirectory2004;andEFTData
Book–2004Edition.
Figure5:Proportionalgrowthrateofcomponentsofelectronicpayments:
Debitcarduseexplodes1991-2003
Source:OCCusingdatafromNACHA;CardIndustryDirectory2004;andEFTData
Book–2004Edition
Ratio of transactions 2003 to 1991
ATM 2.23
Credit card 4.49
ACH 5.87
Debit card 81.87
Technological innovation in retail payments: Key developments and implications for banks
An important feature of the greater-than-previously-per-
ceivedshiftfrompapercheckstoelectronicpaymentsisthe
change that occurred in the use of various components of
electronic payments, such as credit cards, debit cards, and
ACH transactions. Figure 4 illustrates trends in credit card
transactions,debit card transactions,ACH transactionsand,
forcomparison,ATMtransactions.Inthefirsthalfofthe1990s
thesecomponentsofelectronicpaymentsrosemoreorlessin
tandem. Beginning in the mid-1990s, however, debit cards,
whichhadbeeninusesincetheearly1980s,suddenlysurged,
overtakingbothACHandATMtransactions.
Figure 5 puts the growth of debit card use in perspective,
showing that while ATM, credit card, and ACH usage grew
substantially, debit card usage increased more than 80-fold
overthe1991to2003period.Asaconsequenceofthischange
in payment practices, debit cards, which had accounted for
only2percentofallelectronicpaymenttransactionsin1991,
hadrisento29percentofallelectronicpaymentsby2003,a
positionrivalingcreditcardusage(Figure6).
The impact of changing trends in retail payments on the banking industryThe greater-than-initially-believed switch away from paper
checkstoelectronicpaymentshashad,andwillcontinueto
have, a significant impact on the banking industry. Conven-
tional wisdom holds that advancements in retail payments
lowerbanks’operationalcosts,makingthembetteroff than
theywere in themorepaper-intensiveera. In fact,however,
thestoryismorecomplex.Althoughpaymentsystemexperts
considerlong-termprospectsforimprovedbankproductivity
promising,itisfarfromcleartowhatextentbankswillrealize
netbenefits fromchanges in retailpaymentpatterns in the
near-term.7 Such a conclusion rests on a consideration of
developmentsonboth the revenueandcost sidesofbanks’
retailpaymentactivities.
Banks’ payment-related revenueTraditionally,bankshavefocusedtheireffortsondeposittak-
ingandlendingactivities,regardingpaymentservicesinthe
same light as other, less glamorous, back office activities.
However,formanybankspaymentsactivitiesrepresentacon-
99
8 Thereissomeuncertaintyassociatedwithinsufficientfundsfee.Feesforbounced
checksandoverdraftfeesoncheckingaccountshavebecomeanimportantgener-
atoroflow-riskincomeforsomebanks.Moebs(2003)citesaMarch2003report
bytheresearchfirmCelentestimatingthatfeesforbouncedchecksgenerated
between25and50percentofalldepositfeesearnedbyU.S.banks.Notethat
recentlysuchfeeshavecomeunderattackbyconsumergroupsandunderscruti-
nybyregulators.Forexample,bouncedcheckfeeswerethesubjectofaJune
1998reportbytheConsumerFederationofAmericaentitled‘BouncedChecks:
BillionDollarProfitsII.’Numerousconsumeradvocacygroupshaveexpressed
theirconcernaboutbounceprotectionprograms,includingtheiruseasavery
expensiveformofshort-termborrowing.Thoseconcernsarenotlimitedtopaper
checks.Thesamegroupshaveurgedthatfinancialregulationstreatfeescharged
bybankswhenanaccountisoverdrawnwithanATMordebitcardasanunfair
anddeceptivepractice,onthegroundsthatnooverdraftwouldhaveoccurredif
thebankhaddeclinedthetransaction.Seeforexamplecommentssubmittedby
theNationalConsumerLawCenter,ConsumerFederationofAmerica,Consumers
Union,NationalAssociationofConsumerAdvocates,andtheWoodstockInstitute
totheFederalReserveSystemontheProposedAmendmentstoRegulationDD
(August6,2004).Forexamplesofregulatoryresponsestothedebate,see,e.g.,
InteragencyGuidanceonOverdraftProtectionPrograms,andproposedchangesto
RegulationDD(whichimplementstheTruthinSavingsAct),whichwerepublished
forcommentonJune7,2004intheFederalRegister(Volume69,No.109at31858
and31760,respectively).
9 In2003,thevolumeofcreditcardandonlinedebitcardpaymentsgrewatannual
ratesof7percentand27percentrespectively.Thesedifferinggrowthrateshavea
largeimpactontherevenueofbanksthatissuethecards,inlargepartbecauseof
differencesin‘interchangefees’receivedbythecard-issuingbanks.Theinter-
changefeeissignificantlyhigherforcreditcardsthanforonlinedebit.Forexample,
onaU.S.$75grocerystorepurchase,theU.S.$0.91(VISA)creditcardinterchange
feewouldbe6timesgreaterthantheU.S.$0.15PINdebitinterchangefee(specifi-
cally,inthiscase,viatheSTARnetwork).Thedifferenceinmarginincreasesasthe
purchaseamountincreases,becausemostPINdebitnetworkscapinterchange
betweenU.S.$0.15toU.S.$0.60pertransaction,whileVISAinterchangeisgenerally
apercentageofthepurchaseamount(generallybetween1.2%and2.6%),plusa
fixedfeethatisusuallybetweenU.S.$0.05toU.S.$0.10pertransaction.
10 Therearetwowaysdebitcardtransactionscanbemade,eitherthedebitcard
holdercompletesatransactionbysigninghissignature(aso-called‘signature’or
‘offline’transaction),orusesapersonalidentificationnumber(PIN)atthepointof
sale(asometimesreferredtoasan‘online’payment).Ingeneral,merchantsprefer
PINdebitcardtransactionstosignaturetransactionsbecauseinterchangefees
tendtobesignificantlylowerforPINdebit,ultimatelyresultinginlessofadis-
countformerchantsonthevalueofthecardreceiptstheyselltomerchant
acquirers.Note,however,thatdifferencesbetweenthetwotypesofdebittransac-
tionsarenarrowing.TheCardIndustryDirectory2004reportsthatinterchange
feestypicallyaccountfortwo-thirdsormoreofaretailer’scostofacceptingbank
paymentcards.
11 Theinterchangefeesmarkethadbeeninturmoilforsometime,asretailerssawa
steadyincreaseinthediscountratestowhichtheircardreceiptsweresubject.
Manyretailersbelievedtheseexceededthemajorcostsofissuingcardsandpro-
cessingtransactionsthattheinterchangesystemwasoriginallydesignedtocover.
Indeed,someretailersthoughtinterchangefeesshouldhavedroppedsubstantial-
ly,aselectroniccardtransactionsreplacedpaper-basedcardpayments.Wal-Mart
andothermajorretailerschallengedthepricingpowerofthetwomajorcardasso-
ciations(VisaandMasterCard)inaclass-actionlawsuit.Thelawsuitchallengedthe
cardassociations’‘HonorAllCardsRule’requiringretailersacceptingonetypeof
cardbrandedbyVisaorMasterCardtoacceptallcardsbearingthatlogo(i.e.,if
thestoreacceptedbrandedcreditcardstheyalsohadtoacceptthecardcompa-
nies’brandedsignaturedebitcard).Thepartiessettledoutofcourtinearly2003;
asaresultofthesettlement,startinginAugustof2003bankissuersofsignature
debitcardsexperiencedaone-thirddropinmerchantacquirer-paidinterchange
feerevenue.Althoughthisdeclinehasbeenoffsetsomewhatbysubsequent
increasesininterchangefeesforsignaturedebit,andbyincreasesoninterchange
feesforPINdebitcardtransactions,industryexpertsestimatethatinterchange
feerevenuehasdroppedbyapproximately20percentfromthepre-settlement
level.ForathoroughdiscussionofthepressuresoninterchangeseeGiesen
(2004).
12 See,forexample,Porter(2004).Histhreepercentfigureisbasedoninformation
fromaPewHispanicCenterreportreleasedinJune2004.Notethatseverallarge
banks,includingCitibank,BankofAmerica,andWellsFargoareactivelymarketing
remittanceservices.Inaddition,FirstData’s2003annualreportindicatesthatits
WesternUnionaffiliateisencounteringexpandedcompetitionfrombanksand
ATMproviders,whichhavebeguntotargetmoneytransferuserswithnewproduct
offerings.
13 WesternUnioncontributed35percent(U.S.$2.94billionin2003)toFirstData’s
totalrevenue(U.S.$8.4billion)andaccountedforapproximately80percentofthe
revenueinFirstData’sPaymentServiceunit,whichin2003hadanoperatingmar-
ginof34percent.
14 PayPalhasrecentlycompletedtechnologicalinnovationsandhasexpandedits
productofferingstobecomeapaymentsprovideroutsideoftheonlineauction
market.Inparticular,itisrevampingitssalesforcetobecomeapaymentsprovider
forretailers.MerchantswithU.S.$100,000ormorepermonthinPayPalvolume
paya1.9percentdiscountfeeandU.S.$0.30pertransaction.SeeInternetRetailer
(2004)andBliss(2004).
Technological innovation in retail payments: Key developments and implications for banks
The bill payment market is dominated by the CheckFree
Corporation. CheckFree’s electronic commerce division lets
customersreceiveelectronicbillsovertheInternet,paybills
electronically, and make payments not related to bills. The
majorityofCheckFree’scustomersaccessitssystemthrough
banks, including Bank of America, Wachovia, Washington
Mutual,andWellsFargo.FeestoCheckFreeincludeanaverage
U.S.$0.35 charge per transaction for banks that use Check-
Freeforbillpaymentande-billprocessing,andanaverageof
U.S.$0.81 per transaction charge for banks that fully out-
source bill payment to CheckFree [J.P Morgan Securities
(2004)]. It is noteworthy that even though banks pay
CheckFreesuch fees,an increasingnumberofbanksdonot
chargetheircustomersforbillpayment.
Ebay,theleadingonline-auctioncompany,purchasedPayPal,
theleadingonlinepaymentsystem,inOctober2002.PayPal
builtitsonlinepaymentnetworkontheestablishedinfrastruc-
ture of bank accounts and credit cards. During the second
quarter of 2004, PayPal handled U.S.$4.35 billion of gross
paymentvolume(a53percentincreaseoverthesecondquar-
terof2003),generatingU.S.$161.5millionintransactionfees.
Forthesecondquarterof2004PayPal’saveragetransaction
revenue rate was 3.64 percent and its processing expenses
ratewas1.34percent,resultingina63percentmargin.14Note
thatthePayPalsystemhasalsobeguntobeusedforcross-
borderremittances.
Expeditedlatepaymentsaregenerallyfor lastminutetrans-
fers by consumers to pay recurring bills. This is a relatively
newbutrapidlygrowingmarket.Theexpeditedlatepayments
market is led by companies such as Western Union and
MoneyGram. Other non-bank providers of so-called ‘walk-in’
billpaymentserviceshavealsoenteredthismarket,including
AmericanPaymentSystems,whichservicesuptosevenmil-
lion households. Note that American Payment Systems was
acquiredbyCheckFreeinJune2004.
100
2000 2001 2002 2003
Per unit cost — in cents 1.6 1.5 1.3 1.1
ACH volume — billions of transaction 3.81 4.45 4.99 5.59
Figure7:FedACHprocessing:Per-unitcostdeclinesasvolumeincreases
Source:OCCusingdatafromtheFederalReserveSystemandNACHA.
Technological innovation in retail payments: Key developments and implications for banks
banks.11 Finally, banks are not dominating other higher margin pay-
mentsactivitiesthathaveemergedasaresultof,orreceived
aboostfrom,technologicaladvancements.Chiefamongsuch
paymentsactivitiesaremoney transfer (includingespecially
cross-borderremittances),billpayment,paymentsgearedto
the online market (such as PayPal), and expedited late pay-
ments.Withtheexceptionofexpeditedlatepayments,thereis
one dominant, and non-bank, provider in each of these
increasinglyimportantpaymentsmarketsegments.
Moneytransferisoneofthemostimportantfinancialservices
forunbankedconsumersandisdominatedbynon-bankfirms,
suchasWesternUnion(apartoftheFirstDataCorporation)
and MoneyGram. Industry analysts forecast money-transfer
growthof18percentthrough2010,withmuchofthisgrowth
coming from remittances, a payment process that enables
immigrants to send money from the United States to their
home countries. Some banks have recently shown a some-
what belated interest in the remittance market, but remain
smallplayers.Forexample,bankshandlelessthan3percent
oftheU.S.toMexicoremittancemarket.12Anindicationofthe
high-margin nature of the money transfer business can be
inferred from First Data Corporation’s 2003 performance.
FirstDatareportedanoperatingmarginof33percent,duein
parttoa35percentcontributiontoFirstData’stotalrevenue,
and an 80 percent contribution to First Data’s Payment
Servicesunit,byitsWesternUnionsubsidiary;WesternUnion
hasa75percentshareoftheworldwideremittancemarket,a
marketinwhichtheaverageremittancefeeis7percentofthe
amountofmoneytransmitted.13
101
15 Checkelectronificationcanbeaccomplishedviatwobasicroutes.Inthecaseof
‘checkconversion’apapercheckisusedasasourceofinformationatthebegin-
ningofthepaymentprocesstoinitiateanACHtransaction.‘Checktruncation’is
theprocessofstoppingthepaperduringtheclearingprocess,thuseliminating
additionalphysicalhandlingandtransportationoftheitems.Notethatthesame
economicforcesthathavepropelledcheckelectronificationhavealsostimulated
significantimprovementsintheprocessingofpaperchecks.See,forexample,
Greenspan(2003),andFerguson(2003).
1999 2000 2001 2002 2003
Per unit cost — in cents 3.8 4.0 4.5 4.5 5.1
ACH volume — billions of transaction 17.1 17.0 16.9 16.6 15.8
Figure8.Fedcheckprocessing:Per-unitcostrisesasvolumedeclines
Source:OCCusingdatafromtheFederalReserveSystemandNACHA
16 NACHA(anindustrygroupofelectronicpaymentsystemparticipants)isworking
todevelopamechanismtoaddressthisdisparitybyhavingbanksthatoriginate
unauthorizedACHdebitstoaccountspayareturnentryfeethatwillgotothe
receivingbank.
17 TheFederalReserve’sRegulationEcoversconsumercomplianceissuesformany
typesofelectronicpayments.
18 Infact,theexperienceofthesebankshasbeenthatmanyInternetbankingcus-
tomersconductmoretransactions,acrossmorechannelsthannon-Internetcus-
tomers,andhencearecostlytoserve,despitetheiruseoflowercostdelivery
channels.However,netrevenueforcustomerswhouseInternetbankingtendsto
behigher,becausethesecustomersusemorehighvalue-addedproductsandser-
vices,andbecausetheytendtobemore‘sticky’–thatis,theydonottendtoleave
thebank,inpartbecauseofcosts(intimeandeffort)theyincurinsettingupser-
vicessuchaselectronicbillpayment,accountaggregation,etc.
19 Forexample,aMay2004reportbyCelentestimatesthatinternalinformation
technologyspendingonnon-cardpaymentsystemswillgrow37percentover
2003-2004,morethantwicetheincreaseover2001-2002,andthatmassive
investmentincheckprocessingisdrivingthisshort-termspike.
Technological innovation in retail payments: Key developments and implications for banks
added, it is frequently not advisable, or even feasible, to
abruptlydiscontinueolderoptions,evenifthoseoptionsare
morecostlyforabank[DoveConsulting(2004)].Thislesson
was most recently learned by banks that successfully inte-
grated Internetbanking into theiroveralloperations. Inpar-
ticular,bankswithwell-establishedandwell-regardedInternet
bankingoperationsanalyzedcustomerbehavior,anddiscov-
ered that customers adopting Internet banking still wish to
use the bank’s other delivery channels, including branches
and call centers.18 The same dynamic holds true for pay-
ments:customersshiftingtogreaterrelianceondebitcards
maystillwishtohavetheoptionofpaperchecks,forexample.
Underthesecircumstances,banksneedtoascertainthemost
profitablebalancebetweenintroducingnewpaymentoptions
and maintaining (and, over time, possibly de-emphasizing)
olderones.Thisbalancingactrequiresmakinginvestmentsin
newpaymentsystems,butalsocontinuingtoincurcostsfor
maintaining older ones.19 A corollary is that banks face
increased risk-management responsibilities in such areas as
security(includingfrauddetectionandprevention)relatedto
allaccesspointsandpaymentsoptions.
conclusionsTheUnitedStatesstillhasaheavilypaper-basedretailpay-
ment system compared with many other developed econ-
omies,buttheshifttoelectronicpaymentshasbeenbigger
and more decisive than commonly perceived. For the first
timeever, checkusedeclined in themid-1990s,andamong
electronicpaymentstheadoptionofdebitcardshasoccurred
atanextremelyrapidpace.Thesechangingpatternsofpay-
mentsmayeventuallyresultinsubstantialpayments-related
costreductionsforbanks,butthestoryonnet,especiallyin
thenear-term,iscomplexandlessthancompletelysanguine.
Payments-relatedrevenue isan importantsourceof income
forthebankingindustry,perhapsmoresignificantthangener-
ally appreciated, and payments undergird both deposit and
lending relationships for banks. A large part of payments-
related revenue comes from check-related activities, and as
checkusedeclinessowilltherevenuefromit.Itisnotclear
thatrevenuefromincreasedprocessingoflowermarginelec-
tronicpaymentswillfillthegap.Inaddition,changingtrends
inretailpaymentshaveresultedinsignificantchangesinpay-
mentfeestructuresforbanks,includinginparticulararecent
declineinsomecard-relatedinterchangefees.Finallyonthe
revenueside,non-banks,ratherthanbanks,dominatemarkets
for some higher margin, non-traditional payments options,
suchasremittancesandbillpayment,whichhavereceiveda
boostfromrecenttechnologicalinnovations.
Onthecostsidethestory isalsocomplex.Whileelectronic
payments are far less expensive to process than paper
checks, some cost-related factors cut the other way. For
example,ascheckusefalls,scaleeconomiesfromprocessing
largevolumesofchecksdecline.Eventechnological innova-
tionsin‘electronifying’checksentailexpensesthatmustbe
102
Technological innovation in retail payments: Key developments and implications for banks
Banks’ payments-related costsThecommonperceptionisthatchangingretailpaymentspat-
terns have been an important positive development on the
cost side for banks. There is certainly justification for this
view. Electronic payments in general are substantially less
costly to process than paper-based ones. For example,
FederalReserveper-itempaymentsprocessingcosts,which
areillustrativeofindustrytrends,showthatitisalmostfive
times more costly to process a paper check than an ACH
transaction. Furthermore, as the volume of electronic pay-
ments processed increases, economies of scale and addi-
tionalinnovationsarelikelytoenhancethisadvantage.Inthis
vein,Figure7showsthatFederalReserveSystem’sper-unit
ACH processing costs have declined as the volume of ACH
paymentsithandleshasincreased.
However,aswiththerevenuesideofthepicture,thestoryis
morecomplexthancommonlyappreciated.Asaconsequence,
achieving overall payments-related cost-reductions entails
significantchallengesforbanks.Onefundamentalfactoroper-
atingtoconstrainpayments-processingcostimprovementsis
decliningscaleeconomies.Inparticular,ascheckusedeclines
andthescaleofcheckprocessingformanybanksdecreases,
theper-unitcostofcheckprocessingrises.AsFigure8shows
forexample,theFedhasseenasteadyincreaseinitsper-unit
checkprocessingcostsasthevolumeofchecksitprocesses
hasdeclined.
In response to the increasingly unfavorable economics of
papercheckprocessing,industryparticipantshavedeveloped
technological improvements. ‘Checkelectronification’results
insubstantialcostsavings,includingofcoursetheelimination
oftheexpenseandtimeofmovingpaperthroughthesystem,
but also efficiencies such as lower back office costs for
researching past payments.15 Nevertheless, there are sub-
stantialcostconsiderationstotake intoaccounteven inthe
case of such technological advancements. These of course
includeequipment,software,andpersonnel-trainingstart-up
costsforswitchingtonewprocesses.
Inadditiontotheobviousstart-upcostconsiderations,there
aretwopossiblylesswell-recognizedcostsofcheckelectroni-
ficationwithwhichbanksmustdeal.Paymentsecurityissues
poseimportantcostchallengesforbanks.Forexample,many
check fraud protections are currently based on, some even
imbedded in, paper checks. Check electronification innova-
tionsneedtobedesignedtoofferat leastasimilar levelof
fraudprotection,aprocess thatmayentail additional costs.
Additionally,itispossibleforbankstounderestimatepayment
systemupgradecostsbecausetheyfailtorealizetheneedto
properlyintegratepapercheckandelectronic(ACH)process-
es.Inparticular,becausecheckandACHprocessingsystems
have not traditionally been linked, it is possible that, when
checksareconvertedtoACH,cashmanagementriskcontrols
in place for paper check processing may be inadvertently
bypassed,orstop-paymentordersforconvertedchecksmay
notbeactedupon.Banks’checkelectronificationcostcalcula-
tionsneedtotakeintoconsiderationtheproperintegrationof
checkandACHprocessingsystems.
Anadditionalfactoronthecostsidethatwilltendtomitigate
retail payments-related cost improvements for some banks
arisesfromimbalancesinthedistributionofcostsassociated
with some forms of electronic payments. Such imbalances
maybecomemoreonerousasagrowingvolumeofretailpay-
mentsbecomeelectronic.Forexample, in thecaseofunau-
thorizedACHpayments,thecostsarebornebythereceiving
bank(theconsumer’sbank),eventhoughtherevenueassoci-
atedwiththepaymentgoesentirelytotheoriginatingbank
(the merchant’s bank).16 Other ACH-related cost burdens
receiving banks may incur without sufficient compensating
ACHrevenueincludecompliancecosts,forexampleinconnec-
tion with consumer protection, as well as costs associated
withscreeningcross-borderACHtransactions incompliance
withOFAC(theTreasuryDepartment’sOfficeofForeignAsset
Control)requirements.17
Finally,thereisanimportantstrategicissuebanksmustcon-
siderthathasbothcostandrevenuedimensions.Bankshave
learned that when new service options for customers are
103
Future
innovation on networks: coordination, governance, and the case of VisA
The evolution of currency
Automating payment processes to reduce working capital
new agenda for payment service providers
new models of collaboration in transaction banking
European payment service providers: A race to market and the nature of future victory?
network-based payments and e-settlement
Banks’ strategies for payment services: which role for debit cards?
delivering migrant workers’ remittances
check 21 and the migration to electronic payments
1 WethankJamieMcAndrewsforhelpfulcomments.Theviewsexpressedhereare
thoseoftheauthorsandnotnecessarilythoseoftheFederalReserveBankof
KansasCityortheFederalReserveSystem.
innovation on networks:coordination, governance, and the case of VisA
Matthew CardilloAssistant Economist, Federal Reserve Bank of Kansas CityAntoine MartinEconomist, Federal Reserve Bank of Kansas CityMichael J. Orlando1
Senior Economist, Federal Reserve Bank of Kansas City
upproblemlimitsinnovationinaparticularnetworksettingis
critical to identifying ways to enhance network utilization.
Althoughthenetworkeffecthasbeenmorewidelyconsidered
in these environments, solving the hold-up problem may be
thecriticalpathtoincreasednetworkutilization.
The case of VisAThis sectiondescribes theevolutionof theVISAnetwork to
illustrate how network utilization was increased in the pres-
ence of both network and hold-up problems. We argue that
theadoptionofajointownershipstructureintheearly1970s
wascriticaltoVISA’sgrowthandsuccess.
TheVISAcard,asweknowittoday,beganitslifein1958as
theBankAmericard,BankofAmerica'srevolving-creditprod-
uctandoneofthefirstmodernmulti-purposecreditcards.In
the beginning, the BankAmericard program was entirely
underthecontrolofBankofAmerica.Inordertoexpandthe
program,BankofAmericaformedtheBankAmericardService
Corporation,whichallowedlicensedbanksoutsidethestateof
California to issue BankAmericards to consumers in their
regions.Thiscanbeseenasafirststeptowardsmutualown-
ership of network assets, a progression that culminated in
1970withBankofAmerica'sdecisiontotransferownershipof
theBankAmericardprogram,andtheunderlyingnetwork,to
thebanksthathadbeenlicensedissuersundertheprevious
arrangement, creating National BankAmericard Inc. (NBI).
Thus,theassociation,theinnovativeorganizationalstructure
thathasplayedsuchalargeroleinthegrowthofthenetwork,
wasborn.
Apart from joint ownership of network assets, a significant
featureofthisorganizationalstructurewasthatitcalledfor
the centralization of functions that benefited all network
membersjointly.Infact,oneofthemostimportantcentralized
functionsofthenewly-formedorganizationwasthedevelop-
ment of innovative interchange technologies. This coordina-
tionofinvestment—inthiscasetheconsolidationofresearch
anddevelopmentefforts—gaverisetoanumberofkeyinno-
vations, fromBASE1, theworld's firstglobalelectroniccard
authorizationsystem,totheadoptionofthenameandbrand
VISAandacommonfront-endforitsproducts.
WiththeadoptionoftheVISAbrand,theneedtoissueinfor-
mational material and reissue all cards in circulation repre-
sentedsubstantialcosts fortheparticipantstothenetwork.
Suchacostly innovationcouldonlyhavebeenjustified ifall
participantscoordinatedtoinvestinthebrand.Theseinvest-
mentsalsohavethecharacteristicthattheyarespecifictothe
network.Thereisnoobviouswayforaninstitutiondecidingto
leave the network to redeploy the product of this kind of
investmenttoanalternativeuse.Hence,thisexampleisalso
typicalofthekindofinnovationthatisatriskofbeingheldup.
Theefforttoconsolidateresearchanddevelopmentandcoor-
dinateinvestmentscanbeseenasanattempttoaddressthe
network effect. In this network structure, important innova-
tionsshouldbeadoptedbyallparticipantsjointlytoguaran-
teethebestpossiblereturnforagivenamountofinvestment.
However, it could be seen as puzzling that BankAmericard
ServiceCorporationwouldtaketheadditionalstepofsharing
ownershipof thenetwork, since itdoesnotobviouslyserve
thepurposeofbettercoordinationof investment.Given the
valueoftheVISAbrandtoday,onecouldarguethatitwasa
majormistaketosurrendersoleownershipofsuchavaluable
asset.Wearguethatthiswasnomistake,orcoincidence.
Ifonetakesthehold-upproblemseriously,itbecomesappar-
ent that VISA could not be worth what it is today under a
monopolyownershipstructure.Thisisbecausethenumerous
costlyinvestmentsnecessarytoenhancethebrandnotonly
requiretheparticipationofallnetworkparticipantsbutalso
106
107
The‘networkeffect’ isperhapsthemostthoroughlystudied
featureofnetworkenvironments.Participantsareunlikelyto
use a network unless others are already doing so. In many
networksettings,suchastelecommunications,payments,and
software,innovationalsoappearsfundamentaltogrowth.As
such,thenetworkeffectalsostructuresincentivestoinnova-
tionthatdeterminethenetworkdynamic.Thehigherthelevel
ofinnovationonanetwork,themoreparticipantsareattract-
edtoit.Andthemoreparticipantsthereareonanetwork,the
greaterpotentialforinnovation.Butanotherbarriertoinvest-
ment is likely to play a role in network growth. Investment
‘hold-up’generallydescribesthedisincentivetoincurafixed
costwherethevalueofsuchaninvestmentmaybeappropri-
atedbyanotherparty.Thismaybeaproblemforinvestments
ininnovationonownedor‘sponsored’networks,whereaset
of standardsor rulesareestablishedby thenetworkowner.
Indeed,onsuchnetworksinvestmentsininnovationaretypi-
callynetwork-specific.Consequently, it is interesting tocon-
sidertheseproblemsinabstractandaskhowonelargenet-
workwasabletoovercomethem.
Anetworkeffectresultswhenutilizationofanetworkservice
byoneconsumeraffectstheutilizationchoiceofanother.The
telephoneistheclassicexampleofthisphenomena;theben-
efittousingthistechnologydependsonthenumberofother
consumerswhoalreadydoso.Thisproblemfornetworkutili-
zation translates into a similar problem for network innova-
tion. Innovative investment may not be justified if too few
ultimatelyusethenetwork,butmaybejustifiedifmanydoso.
Imagineasituationwhere,ifallnetworkparticipantschoose
to adopt an innovation, the innovation-enhanced network
attractsevenmoreusers.Inthiscase,benefitstoparticipants
associated with the increase in network usage may justify
adoptionandhenceinvestmentintheinnovation.However,if
toofewparticipantsadopttheinnovation,networkusagemay
remain sufficiently low so that the cost of the innovation
exceeds its benefits. Consequently, a network effect is an
important barrier to both utilization and innovation on net-
works.Unlessitispossibletocoordinatethebehaviorofpar-
ticipants,manypotentialnetwork innovationswillneversee
thelightofday.
Theholdupproblempresentsamoregeneralbarriertoinno-
vation.Itplaysamajorroleinlimitinglargeinvestmentsspe-
cifictoaparticularapplication.Thesefeaturesarecharacter-
istic of investment in innovation on sponsored networks.
When an innovation is costly and specific to the network —
meaningthattherearenousesforthisinnovationoutsideof
thenetwork—innovationcanbeheldupbytheownerofthe
network.Consider suchan innovation that isadoptedbyall
participantstoanetwork.Thebenefitsfromtheinnovation,in
the form of increased network usage and/or lower cost, for
example, yield increased profits to network participants.
However,oncethecostoftheinnovationhasbeensunk,the
owner of the network can appropriate these benefits, for
examplebyrepricingnetworkaccess.Potentialadopterswill
bedeterredastheyanticipatetheowner’sbehavior.Potential
innovatorswillholdupinvestmentastheyanticipatenopar-
ticipantswilladopt.
Inordertoovercomethehold-upproblem,thenetworkowner
mustbeabletocrediblycommitnottoexpropriatethevalue
oftheinvestmentfromparticipants.Inprinciple,thiscouldbe
doneinavarietyofways.Forexample,areputationortheuse
of long-term contracts might allow this kind commitment.
Suchmechanismsmaytakealongtimetoestablishorrequire
costlyrevisionsasconditionchange.Aparticularlyeffective
waytoovercomethehold-upproblemisfornetworkpartici-
pantstojointlyownthenetwork.Suchagovernancestructure
insuresthesamesetofinstitutionsreceivesthebenefitsfrom
the innovation,eitherasparticipants inorasownersof the
network.Understandinghowthenetworkeffectandthehold-
arespecific to thenetwork.Hence, inorder toextractmore
valueoutofitsnetworkitwasnecessaryforBankofAmerica
to agree to share it with the other banks that licensed the
creditcards.
Imagineforamomentthat,intheearly1970s,BankAmericard
ServiceCorporationhadproposedtocentralizetheresearch
anddevelopmentfunctionfortheVISAnetworkbutretained
soleownershipofitsassets.Inaworldwheretheonlybarrier
toinnovationisthenetworkeffect,thisstepwouldhavebeen
enoughtospurthegrowthofVISA.However,wehaveargued
thatoneshouldexpectotherparticipantsintheVISAnetwork
torealizethatsuchanarrangementwouldbebadforthem.In
effect, they would be financing costly innovations that
enhance the value of the network but would be unlikely to
partakeinthosebenefits.BankAmericardServiceCorporation,
as the sole owner of the network would be able to reprice
networkaccesstosystematicallyextractallbenefits.Thissug-
geststhattheonlywaytogetothercardissuerstoagreeto
finance network-specific innovations was to allow them to
becomejointownersofthenetwork.
Onemorepointisworthnoting.Atfirstglace,thegovernance
structure of American Express might seem to provide a
counter-example to our story, since, in contrast to VISA,
American Express is not mutually owned. Closer inspection,
however, reveals that there is no contradiction. American
Express,becauseitisaproprietarynetwork,andnotanasso-
ciation,hasnoindependentbanksissuingAmericanExpress
credit cards. Instead American Express functions as its own
soleissuer,meaningthat,unlikeVISA,itischaracterizedbya
verticallyintegratedorganizationalstructure.
conclusionInprinciple,bythelogicofthenetworkeffectargument,coor-
dinationcouldhavesolvedBankAmericard’snetworkproblem.
Inpractice,BankAmericardhadtotakeanextrastepandorga-
nizeunderamutual-ownershipgovernancestructureinorder
to address the hold-up problem. Hence, our argument sug-
gests that there isnomiddlegroundbetween theorganiza-
tionalstructureofVISAandAmericanExpress.Eitherallpar-
ticipantsjointlyownthenetwork,asawaytosolvethehold-
up problem, or a single entity is in charge of a ‘network’,
integratingtheinterestsofdownstreamparticipantsintothe
firm.
As we have pointed out, the hold-up problem is likely to be
particularly serious in cases where costly, network-specific
investmentisnecessarytoimplementinnovationsonaspon-
sored network. Such investment cannot provide benefits to
participantsoutsidethenetworkandthusmakesthemespe-
ciallyvulnerabletobeingexpropriatedbythenetworkowner.
108 - The Journal of financial transformation
109
110 - The Journal of financial transformation
The evolution of currencyJames TurkFounder, GoldMoney.com
Thus,theconceptofamoneysubstituteintroducesanewrisk
intothetransaction,normallycalledpaymentrisk.Itistherisk
that the recipient may not be able to exchange the money
substitutereceivedinatransactionforagoodorservice.The
paymentriskmeansthatthemoneysubstitutemayloseallor
some of its value before it can be exchanged for items of
value.
Formorethan300yearswehavebeenusingmoneysubsti-
tutes.Theirproblemsarereadilyapparent.Papercurrencies
oftenbecomeworthless ifbanks fail,orwhencentralbanks
pursuerecklesspoliciesthaterode,andinsomecasesdestroy,
thevalueofthecurrency.
Furthermore, money substitutes are expensive. They are
based upon credit, and it is costly to monitor credit-worthi-
ness. In addition, substitutes do not circulate efficiently in
onlinecommerce.Therearecostswhenconvertingonecur-
rencytoanother,andmoreimportantly,withnationalcurren-
ciesitisnotpossibletomakeinstantaneousandnonrepudia-
ble 24/7 payments, which have clearly become important
requirements for global online commerce. In short, while
money substitutes have more or less met the needs of the
marketplaceuptonow,theyhavebecomeinadequate.
Importantly,moderncomputerandcommunicationstechnolo-
giesmakepossiblenewformsofcurrency,evenprivatefree-
marketcurrency,suchasGoldMoney.Thedigitalgoldcurren-
cyisdrivenbybottom-lineobjectivestoearnaprofit,incon-
trasttotheoftencapriciousandharmfulpoliticalaimsunder
whichcentralbankersoperate.
Therefore, it is my expectation that currency is about to
evolveyetagain.Globalonlinecommercerequiresit,andso
doesthehighcostofoperatingourpresentcurrencysystem
ofmoneysubstitutes.
BanksintheU.S.earnapproximatelyU.S.$70billionannually,
and it isestimatedthatsome40%oftheirprofit isderived
from their payment systems that enable the money substi-
tutestheycreatetocirculateascurrency.Thatisahighcost
indeedtoconsumersandbusinesses,particularlywhencon-
sideringthatthetechnologyexiststodaytosignificantlylower
thesecosts.
Iexpect,therefore,thatcurrencywillevolveintonewforms.
And, itwillnotbethefirsttimethattechnologyhascaused
profoundchanges.TakethehistoryofPCsasanexample.In
1977corporateITdepartments‘ruledtheroost’andPCswere
ahobbyforahandfulofenthusiasts.Yetintenyears,thePC
hadturnedcorporateITdepartmentsontheirhead.Because
ofdevelopinghardwareandsoftwaretechnology,thePChad
becomeanimportantnewtool,foreverchangingthefaceof
corporatecomputing.Thissamepotentialexiststodayforthe
Internettofundamentallyandforeverchangebankpayment
systems.Asaconsequence,lookfornewcompaniestoexploit
thesenewtechnologies,andintheprocesscreateacurrency
thatonceagainismoney,andnotamoneysubstitute.
111
UntiltheformationoftheBankofEnglandin1694,moneyand
currencywereoneandthesame.Moneywasatangibleasset
andthisassetitselfcirculatedascurrency.
Moneymostoftentooktheformofgoldorsilvercoins,though
historyshowsthatmanyassetshavefromtimetotimeserved
as money. But regardless of what ‘thing’ served as money,
eachsharedonecharacteristic;theywereallatangibleasset.
Consequently,moneyhadvalue in transactionsbecause the
asset being used to represent it was perceived to possess
someinherentusefulnessandwasthereforevaluable.Whatis
moreisthatitwasthistangibleassetthatcirculatedascur-
rency. In other words, though money often took different
forms,withcoinsofpreciousmetalsbeingthemostcommon,
the asset serving as money passed current from hand-to-
hand.
Assetsservingasmoney,however,were inconvenient.Coins
wereheavyandbulky,andthelargenumberrequiredtocom-
pletehighvaluetransactionswasunwieldy.Evenworse,coins
couldeasilybenickedorscratchedinuseandwereworndown
from constant handling, dissipating the precious metal con-
tentthatgavethemtheirvalue.Asaconsequence,goldand
silverwereconsideredtoovaluabletocirculateascurrency,a
realitythatactedanasincentivetodevelopalternatives.And
infacttheselimitationswereovercomebyanimportanttech-
nologicalinnovationfromtheBankofEngland.
It created paper currency, called banknotes, which were a
promissory note obligating the bank to pay the weight of
metalprintedonthenote.Thisnewcurrencyenabledthegold
andsilvertoremaininthebank’svault,withthesepapernotes
circulatingascurrencyinplaceoftheinconvenientandvalu-
ablemetals.
Thisnewcurrencywasthereforeamoneysubstitute,andnot
moneyitself.Thecurrencyallowedtheappropriateweightof
preciousmetaltobepaidondemandwhenthebanknote,on
whichagivenstatedweightofthemetalwasrepresented,was
handed to the bank for redemption. This feature provided
holdersofthenotessomecertaintythattheirmoneywouldbe
returnedtothem,butitalsointroducedarisk,namelythatthe
bankwoulddefaultonitsobligation.
Thisriskofdefaultwasgenerallyperceivedtobeacceptable
giventheadvantagesofferedbythisnewcurrency.Because
bank notes were very convenient and lowered the cost of
transactions, theyofferedsignificantadvantagesovercoins.
Therefore, increasing amounts of bank notes were put into
circulation.Itwasasuccessfulinnovation.However,theessen-
tialnatureofcurrencywasradicallyaltered.
Incontrasttothetangibleassetcommoditiesthatcirculated
ascurrency,banknotesdonothaveanyintrinsicvalue.Their
valueisderivedfromtheassetsbackingthem,thusmakingit
clearthatcurrencyhadbecomeanitemthatrequiresbalance
sheet accounting and double-entry bookkeeping. Currency
wasnolongeratangibleasset,thevalueofwhicharosefrom
theassetitself.Currencywasnowamoneysubstitute,andin
particular,aliabilityoftheBankofEngland,whichpromisedto
paymoneyondemand.
Thereisanimportantdifferencebetweenmoneyandmoney
substitutes, which has its basis in common law, that for an
exchangeinthemarketplacetobeextinguishedassetshave
tobeexchangedforassets.Soifoneusesgoldtobuyahorse,
forexample,anasset(gold) isbeingexchangedforanasset
(the horse), and the instant the assets change hands the
exchangeisextinguished.Therearenolingeringobligations.
Butconsiderthistransactionifoneusesanationalcurrency,
i.e.,amoneysubstitute.
Thenationalcurrency isnota tangibleasset. It isadeposit
liabilityofabank,anditderivesitsvaluefromtheassetsback-
ingit.Therefore,thebuyerinthisexchangewalksoffwitha
horse(anasset)andthesellerwalksoffwithamoneysubsti-
tute (abank’s liability), so theexchange isnotextinguished.
Thereisalingeringobligation,andtheexchangeisnotextin-
guished until the seller manages to exchange the national-
currencymoney-substituteforagoodorservice.
112 - The Journal of financial transformation
Automating payment processes to reduce working capitalKurt CavanoChairman and CEO, TradeCard
Executivestherewerelookingtoautomatethepaymentdeci-
sioning and scheduling processes. The retailer chose not to
implementsoftwareacrossitsprocurementdivisionandhun-
dredsofsuppliers,butinsteadtouseanon-demandplatform
that works over the web. The platform extracts purchase
ordersfromtheretailer’sERPsystem,andthenautomatically
populates and routes other documents necessary for the
transaction,suchassuppliers’invoices.Italsohandlesallthe
informationgatheringandcompliancecheckingthatgoesinto
paymentdecisioningandscheduling,givingthefinanceteam
thefreedomtothinkstrategicallyaboutpaymentsandtheir
timing.Fromatechnicalstandpoint,whatmakesthispossible
isopendataexchange.Asolution,whetheritissoftwareoran
on-demandproduct,shouldbeabletoacceptnearlyanydata
formatandtransport,fromEDIandAS2toXMLandflatfiles.
Thatway,alltheworkacompanyanditssuppliershavedone
on procurement, fulfillment, payment, and workflow is re-
used.Likewise,bothbuyersandsupplierscancontinuework-
ingwiththeirexistinglogisticsandfinancingpartners.
use procurement and payables data to reduce working capitalPoor visibility into and control over payments shrinks the
capitalacompanyhasavailableforotheruses.Withtheright
solution, companies can track relevant data throughout the
procurementcycle,enablingfinanceteamstopreciselyfore-
castcashmovements,planforFX,andbetterinvestthecom-
pany’smoney.
Forinstance,thefinanceteamofacompanyIknowusestheir
procure-to-payautomationplatformtoleverageadvanceship-
ping notices. Suppliers issue these notices when the pur-
chased goods are ready to ship from their factory or ware-
house. Based on the notices, the finance team begins fore-
castingpayablesmuchearlierthantheycouldwith invoices.
Other companies move even closer to the purchase order.
Manycontinuetorelysolelyoninvoices,withtheaddedben-
efitofanautomatedmechanismforcollectingthedata.
In any case, a dashboard or some other reporting tool is
required to precisely manage and exploit this information.
Suchtoolscanprovideeverythingfromabigpictureviewof
paymentstothestatusofindividualtransactions.Havingthis
informationallowsfinanceteamstolowertheworkingcapital
they keep on hand and, in turn, apply funds to higher yield
investments.Italsoimprovesplanningforcurrencyexchange.
Theresult,inshort,istheabilitytofundtherightpaymentsat
therighttimewiththerightcurrency.
113
When CFOs and other finance executives discuss electronic
payments, the conversation typically centers on optimizing
settlement.Butwhatabouttheprecedingsteps,particularly
payment decisioning and scheduling? Payment decisioning
determineswhetherapurchaseorder’stermsandconditions
arefulfilledandreflectedontheinvoice—andinturn,wheth-
ertheinvoiceshouldbepaidoradjusted.Paymentscheduling
encompasses the payment’s timing. Both areas require pre-
ciseinformation,yetaretypicallyrifewithmanualprocesses
and paper. The result is reduced visibility into payables and
bloatedworkingcapital levels.These issuesareexacerbated
when procurement is decentralized, such as at a company
whose multiple divisions use individual purchasing and
accountspayableprocesses.
In contrast, when payment decisioning and scheduling are
executedefficiently,companiescantightlycontrolwhichsup-
pliersgetpaidonwhatdates,aswellasextendvisibilityinto
upcoming payment requirements. This complements elec-
tronicpayment’sprocesssavingswhileenablingcompaniesto
reduceworkingcapital.Forthesereasons,ananalysisofpay-
mentdecisioningandschedulingprocessesshouldbepartof
electronicpaymentinitiatives.
Many companies determine that an automated approach to
paymentdecisioningandscheduling isasensiblesolution—
particularly if the automation layers over existing business
processesandtechnologies,ratherthanrequiringchangesto
them. Below are three best practices for implementing this
approach. They are based on the practical experience of
financeexecutiveswholedsimilarprojects.
start with the purchase orderPaymentdecisioninginvolvescomparingprocurement,fulfill-
ment,andevenwarehousedocumentstodetermineifasup-
plier’sinvoiceshouldbepaid.Automatingthistediousprocess
givesfinanceteamsfasternoticeofupcomingpayments.By
adding automation of payment scheduling, companies can
thensettleinvoicesatthemostfinanciallyopportunemoment.
Mostcompaniesbeginautomationatthepurchaseorder,and
looktoelectronicallysharethisinformation,aswellaslogistics
and payment information, across their own accounting and
procurementdepartmentsandwithsuppliers.Theadvantages
of starting automation at the purchase order are twofold.
Firstly, this approach contributes to overall process efficien-
cies, as information is disseminated faster and more accu-
rately. Secondly, finance teams gain the option to take pay-
mentvisibilitytoitsverygenesis.Withtherightsolution,pay-
m e n t
visibilitycanevenbeaimedat logisticsareas, suchaswhen
suppliersshipgoodsorwhenawarehousereceivesthem.
There are several software and on-demand products that
automatethese‘procure-to-pay’processes.Nomatterwhich
oneanorganizationchooses,itisimportantthatthesolution
be able to base payment decisioning on the comparison of
multipledocumentsandsetsof information.Afterall,many
factorscanbeinvolvedindeterminingwhetherornotasup-
plierhasmettheirobligation.
Another key feature is dispute resolution and negotiation.
Havingautomatedworkflowandcollaborationcapabilities in
these areas can expedite the handling of non-compliant
invoices or inaccuracies in other documents, saving time in
accountspayableaswellasprocurement. It isaparticularly
important capability for direct goods procurement, as slow-
downs anywhere in the supply chain can impact production
schedulesandthecostofgoods.
Extend the value of ERP and other back-end systemsManycompanieshaveputatremendousamountofresources
intoERPandotherback-endsystems.Toexpediteprocure-to-
pay automation, it makes sense to leverage these invest-
ments.Agoodsolutionwillreusetheirdata,suchaspurchase
ordersorshippingnotices,andcomplementtheirassociated
businessprocesses.
Consider the case of a large retailer I recently visited.
new agenda for payment service providersTerry Dirienzo, Director, Group Payments & Settlements, Barclays Plc.Mark Hale, Head of Payments Strategy, Group Payments & Settlements, Barclays Plc.
support these developments. As customers invest in more
electronically integrated business processes, banks must
ensurethattheirpaymentservicescanbeeasilyintegrated.
Critically,asacustomer’sexpectationofserviceincreasesand
their willingness to pay a premium decreases, banks must
seekto improvetheproductivityof theirpaymentsprocess-
ing,clearing,andsettlement.Thiscreatesdemandsandchal-
lengesforeverypartoftheinternalandexternalsupplychain
fromproduct,throughchannelandoperations,toclearingand
settlement. The ability to process payments electronically
fromoriginator tobeneficiary, straight throughandwithout
expensiveintervention,willbeessentialtodrivingupproduc-
tivityandquality.
Inviewoftheextentof informationtechnologyemployedin
thesupplychaininfrastructure,managersmusttakeaccount
oftheITprocessingandcostbenchmarksofsimilarITenter-
prises,andachieveatleastthesameorsimilarlevelsofasset
utilizationandratesofreturnoncapitalemployed.
Everybankhasadifferentpaymentsserviceandproductmix,
as well as a different marketing strategy, which will largely
determine the process and operational requirements that
needtobesatisfied.Equally,bankswillbeatdifferentstages
of organizational evolution, which will determine the extent
andnaturetowhichanintegratedend-to-endpaymentssolu-
tionisavailabletocustomer-facingbusinessareas.Thecom-
bination of these factors will then help identify the most
appropriate organizational and delivery decisions for actual
productandservicedelivery;inparticular,identifyingtheser-
vices that should be processed internally and those that
shouldbepurchasedexternally.
Thebanksthatwillsucceedandgaincompetitiveadvantage
under these conditions will be those that can develop out-
standingpropositionstocreategenuinecustomervalueand
thatoptimizetheirsupplychainbycombiningacompetitive
unitcostwithexcellentservicedelivery.
organizational philosophyInassessingtheoptionswithwhichtomeetabank’spayments
needs,itisimportanttorememberthatpaymentsisonlyone
elementofabank’sbusinessandthatanyorganizationaldeci-
sionsforpaymentsmusttakeaccountofthewidercontextin
whichtheyoccur.Centraltothisiswhetherabankhasacen-
tralized or a decentralized structure for measuring the suc-
cessofitsproductsandservices,whichincludesthewaythey
aremanagedanddelivered. Ifthestructureiscentralized, it
provides for decisions to leverage shared infrastructure, to
offer a manufacturing service for payments, and to obtain
highratesofassetutilization.Ifthestructureisdecentralized,
thenamoredistributeddeliverycapabilityispossible;trading
higherfixedcostoverheadsforgreaterflexibilityandcontrol.
Theabilitytoadoptamoreexternalizedsourcingmodelwill
alsodependtoaverylargedegreeontheextenttowhichthe
existingpaymentsinfrastructureandoperationsareseparat-
ed,colocated,rationalized,oroptimized.
A bank’s fundamental perception of payments will dictate
how they approach this choice. In particular, for example,
whether payments are regarded as a source of value, an
applicationofcost,oranelementofrisk.Thisdecisionisnot
exclusiveorone-dimensional,sincetheperceptionmaydiffer
depending on which part of the supply chain is being con-
sidered (payments, clearing, or settlement), the customer
segmentbeingtargeted(retail,corporate,orfinancialinstitu-
tion),orthedriveroftheactivity(interoperabilityordifferen-
tiation).
Ifpaymentsareregardedasacost,anon-differentiatedcom-
modity,andahomogeneousproduct,thenthiswilllenditself
to a centralized structure and to more external sourcing.
Whereasamoreprofit-orientedtreatmentofpayments,that
114 - The Journal of financial transformation
115
The business of making payments should be high on the
executiveagendaofeveryfinancialserviceprovideroverthe
nextfiveyears.However,itisabusinessineverysenseofthe
wordandthismeansthatmanagershavetoreconcileprovid-
ingcustomerswiththemostrelevantandvalueaddingpay-
mentservices,whileat thesame timedoingso in themost
cost-effective and responsible manner that mitigates the
inherentinvestmentandbusinessrisks.
Customersexpecttheirbankstomakepayments,tohavesuf-
ficient payments reach, and to be able to make their cash
management more efficient. The business of payments is,
therefore,acorecompetenceofabank in thesamewayas
lendingmoneyandprovidingsavingvehiclesarecorecompe-
tencies,exceptthat it isthe lynchpinofthethree,sincethe
othertwodependonpaymentstofunction.
The unprecedented change in the business environment,
relentlessincreasesinthelevelaswellasthenatureofcom-
petitioninthemarketplace,andmoresophisticatedcustomer
demands,therefore,createademandingandurgentagenda
forallpaymentserviceproviders.
Payments landscapePaymentsarealsothelifebloodofcommercialactivityandas
such they underpin the operation and the confidence that
makeseveryeconomyfunction.Inaninformationtechnology
era,therefore,itisimperativetoensurethatdeliveryofpay-
ments isefficient, safe,and trusted; irrespectiveofhowthe
paymentsareactuallyprovidedwithinthesupplychain.
Customers have an extremely high expectation of payment
serviceperformanceandavery low tolerance threshold for
paymenterrors.Thisplacesapremiumonthevariousways
that the channel, product, and service strategies of banks
addressthematterofpaymentsandinparticularinhowthese
productsandservicesaresourced.
Theapplicationofinformationcommunicationtechnologyto
enable real-time transfer of value, to support daily transac-
tional values that sometimes dwarf the GDP of many coun-
tries, and to provide international transaction processing
means that the payments business has an extremely high
inherent level of operational risk. Banks, therefore, have to
fullyunderstand,manage,andbeable tomitigate theman-
agementrisksinvolvedintheirpaymentsservices.
Independentlegacysystems,oftenwithproprietarytechnolo-
giesandsystems,arebeingchallengedbytheconsolidation
andglobalization that isoccurring inupstreamclearingand
settlement and in downstream customer treasury and cash
management.Thisisbeingacceleratedbystandardsconver-
genceandtheuseofmoreopenstandards,therebyallowing
greateraccesstonewentrantsandopportunitiesforkeener
competition.
Theeconomicimportanceofpaymentsalsomeansthatmar-
ketmakersandregulatorsareseekingtoachievetheirgoals
and ambitions by homogenizing payments activity within
theirrespectivecountriesandalsocross-border.Thisispar-
ticularlytruewithinEurope,wherewiththeSingleEuropean
PaymentsAreaisbeingusedasameanstoachieveasingle
Europeanmarket.
The challenge for banksThepaymentscontextandlandscapemeansthatbanksneed
to deliver payment solutions that their customers value, in
the manner most attractive to those customers and in the
timescalethatfitstheirownplansandactivities.Ascustom-
ers themselves adopt new technologies, so too must banks
adapttheirpaymentsolutions.Thisisparticularlytrueofthe
Internet,wherecorporatecustomersareusingittoimprove
their own customer experience, to broaden their proposi-
tions,andto improvetheirworkflowandcashmanagement
cycles. It isessentialthatbanksanticipateandarereadyto
howtheserviceisdeliveredtheriskandtheresponsibilitywill
alwaysremainwithinabank.Thecombinationofthesethree
regulatorypillarsmaycausemanybankingexecutivestobe
nervousofallowingthirdpartiestomanagesubstantialpor-
tionsofoperationalriskslikethoseinherentinpayments.
market development conclusionsThe management of the payments supply-side is complex,
risky,andsubjectofsubstantialfuturechange.Anythirdparty
seeking to provide compliant solutions will want to ensure
thattheirpricingincludesapremiumfortheserisksandwill
probablyshyawayfromabsolutewarrantiesandassurances
aboutobtainingcompliance. It isnot thechange that is the
primaryissuehere,butthefactthatchangeiscertain,willbe
mandatory,andyetdifficulttoquantify.
It isclear,however,thatbankswillcontinuetodeveloptheir
outsourcingandoffshoringexperience.Giventhediscussions
above,theshorttermupstreamsupply-sideislikelytodevel-
opinthefollowingways.Bankswillfocusonmakingimprove-
mentstointernalprocessingcapabilitiestoallowmorethird-
party sourcing solutions to be considered. There will be
increasedstandardizationofpaymentsactivitiestofacilitate
migration to different sourcing models. More co-sourcing of
commonprocessingactivitiesinthenon-competitiveareasof
clearing and settlement will be undertaken. There will be
greater consolidation of clearing and settlement activities,
which will be accelerated by the development of the Single
European Payments Area. Selective third-party sourcing of
discreteandnichepaymentsbusinessactivitieswillbecome
moreprevalent; this isanarearipefor jointventuring.And,
third-partysourcingofinfrastructuremanagementandsome
operationsmanagementwillcontinue.
Knowledge management as a separate and managed disci-
plinedoesnothaveanestablishedhistoryinbankingandthis,
aswellasothercriticalpre-requisitedisciplines,willneedto
be established before banks are able to safely migrate sub-
stantialpartsoftheirpaymentsbusinessestothirdparties.
Final commentAnumberofcommentatorstalkaboutbankssimplyoutsourc-
ingtheirpaymentsbusinessestoreducecost,butthisseems
tounderestimatetheoperationalrisksinvolvedandthevalue
ofpayments to thebusinessofbanking.Theyalsooveresti-
matetheabilityof thesupply-sidetomeetthefull rangeof
commercialrequirementsinvolved.Itseemsmorelikelyinthe
long-termthatbankswill,eitherunilaterallyorinpartnership
withothers,establishatransactionalprocessingutilitytopro-
videpayment-processingservicestootherbanks.Intheshort-
term, the focus ismore likely tobeamixedsourcingmodel
withafocusonraisingprocessingproductivityandimproving
servicequality.
116 - The Journal of financial transformation
perhapsservicesnicheandprofitablepaymentsmarkets,will
lend itself to internalmanufacturing,sellingof transactional
services,andsomedecentralizationofnicheactivities.
sourcing modelsManagersconstantlyaddress thequestionofhowtosource
eachcomponentofthesupplychain.Dependingonthescale
ofthecomponentinquestion,thisrangesfromin-housedeliv-
ery to facilitiesmanagement, jointventure,or fulloutsourc-
ing.Withineachcategorytherearethenotherkeyconsider-
ations, such as packaged or bespoke services, offsite/near-
shoresourcing,orfinallyfulloffshoresourcing.
The considerations within each of these options are fairly
standard and best practices also fairly well established and
understood.Muchofthisiscodifiedandavailableinreference
texts. The issue is principally one of information systems,
infrastructure,andinformationtechnologyservicesmanage-
ment.However,where there ismoreuncertainty,andmuch
lessguidance,isinhowtoapplytheseoptionstothebusiness
ofpaymentsandinsuchawaythatsatisfiestheprudential
requirementsofa regulatedcredit institution.The inherent
and systemic risks involved in the payments business is of
such an order of magnitude different to other business
activitiesinotherindustriesthattheCommitteeofEuropean
BankingSupervisorshasestablishedprinciplesforoutsourc-
ing material activities, made such decisions the subject of
pre-notification, and prescribed the outsourcing of certain
specifiedactivities.
Atamorecomponentlevel,banksalreadyutilizeamixtureof
differentsourcingsolutionstomeettheirneeds.Thismaybe
to take advantage of scale economies or to white label the
delivery of particular software products. In every case it is
essential that the customer is unaware of this and that the
actualsupplieroftheproductorserviceisnottransparentto
them.
Payments is a relatively homogeneous product in isolation
andthereforesubjecttosupplierswitching.Thismeansthat
sourcingfromcompetitorswithoutnon-competeandsecrecy
agreements is particularly fraught and carries the risk of
brandandreputationdamage.Where,forexample,isthecom-
mercial incentive for a competitor supplier to offer a good
serviceiftheyareabletoapproachthecustomerinquestion
andsubsequentlysolicittheirbusiness?
Key sourcing considerationsCommercialconsiderationsalsomakeoutsourcingofthepay-
mentsbusinessparticularlycomplex,andBasleIIexacerbates
this.Therearemanysubstantialcreditexposuresinthepay-
mentssystemsatanytimeduringthedayandthesearesub-
jecttocollateralizationandreserve.Normalbusinesspractice
istomatchriskwithcontrol.But,wherecontrolofpayments
isinthehandsofathirdpartyitishardtoconceivethatthese
exposurescouldeasilybecoveredbyliabilityagreements,itis
easytoseetheinsurancepoolbeingconsumedbyamarketof
several‘pure’paymentserviceproviders,andthereareonlya
feworganizationswithabalancesheetcapableofsustaining
thecontingentliability.
Additionally, given the mission critical nature of payments
processing,thelevelofinherentrisk,andthefixedoperating
deadlinesforclearingandsettlementwhereservicesareout-
sourced,thereisapremiumforexcellentserviceintegration
and issue management capabilities. This is particularly the
case in a mixed sourcing environment. In addition, where a
bank isaccustomed tounderstanding the imperativeofsys-
temicandregulatedstability in issuemanagementandused
toplacingtheseconsiderationsbeforeimmediatecommercial
concerns,therecouldbeariskwhenthereissubstantialthird-
partysourcing.
UnderSarbanes-Oxley,bankexecutivesaremoreclearlyand
directly accountable for the effectiveness and operation of
their internal control environments. Under Basle II more
effective operational risk and incident management will be
required, as well as a much better information reporting
capability.TheCommitteeofEuropeanBankingSupervisors
doesnotallowriskmanagementtobeoutsourced.Nomatter
117
new models of collaboration in transaction bankingWolfgang GaertnerChief Information Officer, Global Banking Division — Global Transaction Banking, Deutsche Bank, and, Director, SWIFT
dollar clearing market has seen the disappearance of 59 of
the 115clearinghouseparticipantsduringthe last tenyears
— more than 50 % of the market players have disappeared
(CHIPS statistics). This supports the hypothesis that as the
consolidationprocessof the transactionbusinesscontinues,
therewillonlybeafewbanksthatwillhavethetransaction
volume,andhencethescaleofeconomyatthelowertransac-
tion revenue margins, to meet the customer demands. The
restneedtothinkaboutnewwaysofdoingbusiness—coming
backtothecarbuilderanalogy,thinkingaboutbreedingcattle
oroutsourcingthefarm.
new ways of partnering between banks Outsourcing to another bank may not only serve to reduce
costs, but can enhance the existing offering to customers
wantingmorecomplexservices.Itmayevenimprovethecost
basisofcertainpartsoftheback-endvaluechain.Thereare
possiblythreewholesalebankingproductsandservicesthat
arepartofthistrend:
■ Whitelabelingoffront-endtechnology—namelyInternet-
basedservices,suchaselectronicbankingplatformsand
nettingsystems.
■ InfrastructureoutsourcingofITandoperationswithtrans-
actionroutingandconversioncapabilities,transaction
settlementoptionsandlockboxservicesbeingpopular
choices.
■ Partnerbankingsolutions,includingaccountandliquidity
managementservices,infrastructureandplatforms
aroundcommonservices,suchassales,implementation,
andcustomerservicemodels.
Fundamentaltopartnershipsistheselectionofasuitablesup-
plier. Key benchmarks are a commitment to quality, price,
reputation,andresources.Clientswouldseelittledifference,
as such banks would provide the same depth of the value
chain, by outsourcing services to larger institutions. Thus,
bankscouldmaintaintheirrelationshipsandclientinteraction
withoutthecostandeffortofmanagingtheentireprocess.It
also frees up banks to move further up the value chain to
meet thedevelopingneedsof theircorporateclients.Banks
can lookathowandwhere theycancontinue toaddvalue,
especially for multinational corporations, by helping compa-
niestomanageliquidityacrosstheirglobaloperations.Thus,
these new business models, with cooperation between all
types of institutions, could allow for more efficiencies and
lowercostsforall.
One example for white-labeling is the cooperation between
Barclays Bank and Deutsche Bank. Such strategic partner-
shipscouldonlybepossibleduetoexcellentITandoperations
capabilities,andshowsthatthesefieldshavebecomekeydif-
ferentiatorsandcriticalsuccessindicators.Themandatefrom
Barclayscamewiththeresponsibilitytoprovidepremierser-
vice,bestqualityandhighestsystemavailabilitytothebank
and its clients. This is the first partnership of its kind in
Europe,wherealeadingprovideroffersitscashmanagement
franchisetoanotherfinancialinstitutiontoserveitscorporate
clients. By leveraging Deutsche Bank’s infrastructure and
technologyinvestments,BarclaysBankcannowofferstate-of-
the-artpan-Europeancashmanagementsolutionstoclients,
including account services, domestic and international pay-
mentsandcollections, liquiditymanagement,andelectronic
banking solutions. They will, of course, continue to provide
accountandpaymentservicestotheircustomerswithinthe
U.K.andretainfullresponsibilityforclientrelationships,while
Deutsche Bank will oversee operations and processing, the
management of its services, and also extends support to
Barclays’sales,implementation,andcustomerserviceteams.
In such a scenario, there are winners all around the table.
Banks unable to maintain a stand-alone cash management
businesscanbuy-inservicestoprotecttheircustomerbase,
reducetheircostandrisk,aswellasgeneraterevenue.The
vendorbankleveragesits infrastructureandsystemsinvest-
ments, as well as its high-volume processing efficiencies, to
create an alternate stream of revenue. Finally, corporations
andinstitutionsstandtobenefitfromaccesstoproductsand
118 - The Journal of financial transformation
119
Intheworldoftransactionbanking,changehasalwaysbeen
incremental and not fundamental. But not anymore, the
industryistransformingitself,andatgreatspeed.Itishard
to believe, but instituting such fundamental changes will
force some banks and financial institutions to move away
fromtransactionbankingaltogether,whichwasonceregard-
edtobeacorebusiness.Thesenecessarychanges,whennot
totally successfully implemented, can become a costly pro-
cessandinvolvehighoperationalrisks.
Nowwhatexactlyare thedrivers forchange in transaction
banking?Wehaveincreasingcompetitionwithinadeclining
margins scenario, a growing set of demanding regulations,
greatercustomerexpectations,massive IT investmentsand
growingexpertiseasaprerequisite,newmodelsofcollabora-
tioninthefinancialindustrysector,andtheresultingindustry
consolidation. Understanding these drivers is key for the
financedirectorandcorporatetreasurer,astheywillhavean
impactonhowacompanymanagesitsfinancialtransactions.
It istheseverydriversthatwillalsochangethetransaction
bankinglandscapedramatically.
While competition is increasing, the transactionmarketwill
undergoastrongconsolidationasbankstrytocometoterms
withallthechangesthatourindustryisfacing.Theylookat
what services they should and are actually able to offer to
theircorporateandinstitutionalclients.Itwillbeincreasingly
difficultandinvestment-intensiveformanytransactionbanks
tooffer thecompletesuiteof transactionservices in-house
and manage the investment that goes hand-in-hand with
that.Theresult:nothinglessthanparadigmshifts.
Thereistheoldsayingaboutcarmanufacturers,thatatsome
stage their vertical range of manufacturing would get so
extensivethattheywouldeventuallybreedtheirowncattlein
ordertohavetheleatherforcarseats.Whileitisclearthat
thissituationhaschangeddramaticallyinmanufacturing,itis
lessobviousthatthisiswhatbanksaredoingintoday’smar-
ketswhenitcomestotransactionbanking.
Now that transaction banking has become a commoditized
business, with transaction fees decreasing, clients look for
lower prices and increased capabilities. Yesterday’s order-
winningcriteriaarejustnormaltoday,sotherequirementto
deliver truly complex solutions and the ability to process
scalehasincreasedsignificantly.Inaddition,adifficultglobal
economyandaharsherregulatoryenvironmentareputting
morepressureonbanks.Theever-increasingnumberofregu-
lationsisanadditionalcostdriver.Forexample,TARGET2will
resultintherealizationofasinglereal-timesettlementsys-
temforEurope.Similarly,theanti-moneylaunderinglegisla-
tionandtheU.S.PatriotActwillrequirefurtherinvestments.
Andwhilelarge,globalprovidershavethesystemsinplaceto
comply,smallerbankswill find ithard.BoththePatriotAct
andtheSarbanes-OxleyActplaceemphasisoninternalcon-
trols,transparency,andtraceabilityofdata.Furthermore,the
U.S.CheckClearingforthe21stCenturyAct(Check21)means
thatmostchecksnowneedtobeconvertedintoimagesand
manypaymentswilltaketheformofe-checks.Marketforces
andregulatorychanges,suchastheE.U.regulationoncross-
border payments in Euroland, affect transaction processing
profitability.AtthesametimetheestablishmentofSEPA,the
SingleEuroPaymentsArea,resultsinthenecessarydevelop-
ment of new and better systems. IT specialists, better
straight-trough-processing (STP) rates,and investmentgov-
ernanceandcontrolprocessesareneeded.
Astherequirementforoptimizationandpressureonbanksto
achievefastoperationalefficienciescontinues,smallerbanks
must individually evaluate their capabilities. This could
requiresomepainfuldecisionmakingbeforeproceedingwith
capital investment to enhance existing or purchase of new
payment applications to support new IT infrastructures, or
eventoenhanceSTP.
Should banks, therefore, maintain payment processing in-
house,makeastrategicdecisiontosetupatransactionbank
and in-source, or make a strategic decision to outsource to
one of the global payment providers? For example the U.S.
mentinstructionsreceivedfromourcustomers),whichcould
notbeprocessedstraightthroughandrequiremanualinter-
vention.Withthisimplementationallformermanualinterven-
tion functionswill resideononeapplication,enhancingpro-
cessingspeed,STP,andefficiencygreatly.Ineffect,withthis
break-through installation,DeutscheBankwillruntheirpay-
mentsbusinessonthesameplatformglobally,andthisisfor
all processing hubs in all major currencies. This single plat-
formalsomaximizestheimpactofthedesiredglobalopera-
tion model. The architecture behind MTNA is specifically
designed to support the planned key strategic initiatives,
among them the full multi-entity functionality required to
undertake in-sourcing or private label processing, artificial
intelligencecomponentsandlearningcapabilities,makingthe
repair/STP processes more efficient than ever before and
providing the basis for state-of-the-art delivery of advising,
andreconciliationanddecision-supportinformationtoclients.
MTNAcomprisesasinglesystemwithcommoncomponents
foreuro,U.S.dollar,sterling,andmulti-currencyclearingand
comeswithafullarrayofconditionalpaymenttriggers,which
will become increasingly important in a real-time payments
environment. Importantly, customers will not need to adopt
new technology; they interface with MTNA in a number of
ways,amongthemSWIFTorotherproprietaryDeutscheBank
payment offerings. MTNA is an example of how global and
completeITstrategymustdeliverinthedaysofmarketcon-
solidation and new ways of doing business in transaction
banking,andhowITcanhelptodifferentiateabankfromits
competition.
conclusionWhen it comes to transaction banking, large technology
investmentsandtheirunderlyingcontrolprocessesareneed-
edjusttostaycompetitiveandtocomplywithregulations.For
financial institutions, the resultingconsolidation leads to in-
sourcing and outsourcing decisions at the same time.
Especially,banksare in thedualpositionofbeingbothcus-
tomersofotherbanksaswellasserviceprovidersforcorpora-
tions.Therefore, theyhave tobeclear in theirdecisionson
howtopositionthemselveswithinthecontextoftheindustry
drivers.
Financialinstitutionsarerequiringmoreandmorefromtheir
payment service providers because their customers are
demandingmore.Thereforeeachbankhastoaskitself,what
paymentservicescantheyprovideandatwhatcost?Howcan
they make such payment processing competitive and from
wheredotheyprocess?
The ongoing market consolidation is a result of the market
necessitytoofferthefullglobalsuiteoftransactionbanking
productsat competitiveprices.Consequently, large transac-
tion banking providers will be able to provide in-sourcing
activities and white-label services for the mutual benefit of
their strategic partners. This has resulted in consolidation
among transaction bankers and has led to a greater accep-
tanceofoutsourcingasaviableoptionastechnology,regula-
tion, compliance, and contingency. There is also a growing
recognitionthattheneedtomeettheserequirementsraises
thebarontheinvestmentsrequiredforcurrentprovidersto
remaincompetitive.
Today’s transaction banker will have to recognize that the
demands of customers must be met. These demands cover
suchaspectsaslowtransactionprice,responsiveservicelev-
els, fasterprocessingwith theability toaccept transactions
closertopaymentcut-offtimes,provisionofaccuratetransac-
tionprocessingsupportedwithfastresearchofenquiryproce-
dures,andtheprovisionofaddedproductfunctionality.MTNA
coversthesedemands,andisanexampleofhowITcanserve
asadifferentiatorinadifficultmarket.Itisalsoanexampleof
how an effective IT architecture, combined with the use of
globalmodules,andastrictinvestmentcostgovernanceover
underlying processes, have helped enhance the transaction
bankingcapabilitiesofDeutscheBank.
120 - The Journal of financial transformation
servicestheywouldnototherwisehavebeenabletoprocure
throughtheirhousebank.
Anotherexample,thistimefortheoutsourcingprocesstaking
placeat thesametime, isDeutscheBank’spartnershipwith
Postbank.OnApril6th,2004,DeutscheBankAGandPostbank
signedtheagreementthatthelattertakesovertheprocess-
ingof the former’sdomesticpaymentsaswellas thepaper
handling of Deutsche Bank’s cross-border payment opera-
tions. Postbank now processes the German domestic and
parts of the foreign payment transactions for us. For both
banks, this cooperation is a step in the implementation of
respective strategic objectives. Postbank is continuing to
expanditsdomestictransactionbankingbusiness,leveraging
theirresources,whileDeutscheBankwillbeabletoconcen-
trate on their core transaction banking businesses. For the
banks’ clients, nothing will change. Their accounts will con-
tinuetobekept,asbefore,withtheirrespectivebanks.
Postbank is already one of the market leaders in payment
transactions with approximately 10 million transactions per
day.BasedontheagreementtohandleDeutscheBank’spay-
menttransactions,andthisisinteresting,alongwithDresdner
Bank’spayments,agreeduponinMarch2004,Postbankwill
haveamarketshareofover15%ofthedomesticpaymentsin
Germany. Inreturn,Postbankwill transfertoDeutscheBank
its U.S. dollar clearing business and its worldwide foreign
transactionbankingoutsideoftheE.U.DeutscheBankisthus
strengthening its core competencies in offering global cash
managementsolutionsandthesettlementofforeignpayment
transactions, inparticular for institutionalandcorporatecli-
ents. As a result, both parties are advancing by taking con-
cretestepstoachievejointsynergiesintransactionbanking.
Technology as an enabler Asmentionedbefore,intransactionbanking,IThasbecomea
hugedifferentiator.CuttingcostsbyenhancingSTP,reducing
operational risk, and catering for global platforms have all
become paramount. Major players will need to continue to
invest inplatformsandcapabilities.Betterbackofficecapa-
bilitiesandenhancedSTPratesarepreconditionsforachiev-
ingmarketconcentrationandstandardizationwithinthepay-
mentsbusiness.Thefollowingdriversneedtobefullyunder-
stood when STP and back-office automation are to be
increasedtocompetitivelevels:Assessingbackofficerational-
ization trends; streamlining processes and systems across
regions to deliver benchmark cost transaction processing;
understandingtheupcomingchallengesforcentralandcom-
mercial banks arising from the E.U. accession; restructuring
the back office and delivering benefits through outsourcing
andin-sourcing;examiningthecurrentdriversforSTP,assess-
ingthelatestdevelopmentswithinE.U.paymentsregulatory
requirements; and functional and analytical clarity on effi-
ciencygains,expensecontrol,reducederrorrates,increased
scalability,andoperationalrisk.
Itisahugeandcomplextasktoprovideefficientandrobust
solutionsacrossdifferentregulatoryenvironments,real-time
reporting, investigations and analysis requirements, tax
issues,andformatsandclearingmechanisms,tonameafew
of thechallenges. Forexample, theGlobalMessagingArchi-
tecture (GMA) project addresses these requirements, while
MoneyTransferNewArchitecture(MTNA)isaglobalinitiative
toreplacesegmentedregionalHighValuePaymentsprocess-
ing systems in Germany, the United States, and the United
Kingdomwithglobalmodules.MTNAisanewstate-of-theart,
component-based processing system. The major component
of the U.S. release, which is now up and running, is an
enhanced liquidity management and clearing module. This
managesthegatewaytotheFederalReserveBankandpro-
videstoolstomonitorandmanageintra-dayliquidity,clearing
channelaccounts,andparticipantpositions.ThePartySearch
Engine component is a look-up tool that provides speedy
accesstobankinformationneededtoqualifyandrepairpay-
ments.
The manual entry and repair system module includes func-
tionality to repair and approve outward payments (i.e. pay-
121
122 - The Journal of financial transformation
Paymentshavelongbeencentraltoabank’svalueproposi-
tion.However,on-goingcustomizationofthepaymentsindus-
try, the advent of the euro, and the emergence of a Single
EuroPaymentsArea(SEPA),arenowforcingEuropeanbanks
toreconsiderexactlyhowtheirpaymentspropositionsshould
evolve.Emerginginfrastructurestandards,suchasSwiftNet
and EMV, payment solutions, such as EBA Step 2 and
VisaDirect,andboth‘e’and‘m’channelsareallforcingpay-
mentsplayers to faceup tosomekeyquestions relating to
theirbusinessstrategyintheyearstocome.
In order to remain competitive, European banks are being
forcedtomakestrategicdecisionsaboutwhereandhowthey
willoperatewithinthedifferent‘valuewebs’currentlyemerg-
ingacrossthe landscape.Theriseofmorecustomer-centric
paymentssystemsareforcingbankstoreexaminetheirpay-
ment value propositions in light of both changes to market
infrastructuresandtheincreasedcompetitivethreatposedby
fast-movingnewentrants.Thetimewouldappearripeforthe
creationofapaymentutilitiesmodel,designedtoallowbanks
to share costs, minimize risks, and better utilize funds that
wouldhavepreviouslybeensunkintopaymentsinfrastructure
purchases.Yet,theevidenceshowsthatveryfewutilitymod-
elsthusfarhavemanagedtogainsignificanttractioninthis
market. While this track record has not impressed the pay-
ments market to date, there are signs that the situation is
changingandthattherealityofasuccessfulutilityisstarting
tomaterialize.
why BsPs have underperformed so farHistorically,thepaymentsmarkethasbeencharacterizedby
highlevelsofcompetitiveconcentration,withasmallnumber
oflargebanksdominatingdomesticpaymentsprocessingand
clearingbusinesses.Thesestructureshavetraditionallybeen
locallybased.Manyexistingnationalpaymentsystems,whilst
oftenefficientatadomesticlevel,arefragmentedandfailto
satisfyE.U.commissionrequirementsforSEPA.Thearrayof
institutionsthroughwhichpaymentsmustcurrentlypasshas
alsobeenabarriertoefficiencyinthismarket.Theseinstitu-
tions also face a trade-off between processing volume and
unit pricing, with higher unit costs often resulting from the
varietyofmechanismsinplace.
Consequently, the demand for a shared payments business
serviceprovider(BSP)platform,withsufficientscaletoobtain
efficientcostparameters,hasemerged.Theseemergingmod-
elsarecreatingamarketforoutsourcinganddrivingfinancial
institutions to invest in innovative, revenue generating new
ventures.TheseBSPsofferfullservicecapabilities,delivering
bothbusinessprocessesandtechnologyservicestothirdpar-
tiesandarerunbypeoplewithexperience inoperating the
business.Suchplatformswouldrequirethecooperationand
collaboration of a number of nationally dominant players,
workinginconcerttowardacommongoal.Todate,franchise
conflict, substantial implementation costs, and a number of
socialchallenges,particularly incontinentalEurope,haveall
provedtobesubstantialbarriersandthusfarthecostofthese
have outweighed the benefits of large-scale bank collabora-
tioninthepaymentsspace.
SomebankshavedippedtheirtoesintotheBSPwaters,but
genuine success stories are few and far between. In fact, a
reviewofpastBSPventuresrevealaresultsspectrumranging
from underperforming attempts like European Transaction
Bank(ETB),Finforce,andArcordia,throughtopartialsuccess
stories likeProponix.Additionally, therearea fewemerging
ventures where the verdict is still unclear. BSPs that have
failedtobuild thenecessarymomentumformarketsuccess
haveessentiallynotsucceededinattractingthelargenumber
of client banks required for such a scale-driven business
model.Infact,theyhaveneverachievedthemarketcredibility
neededtobuildacriticalmassofparticipanttransactionvol-
ume.TheProponixventurehasenjoyedsomemomentum,but
challenges around market pricing have prevented it from
developingintoafull-blownsuccessstory.Thesemixedmar-
ketresultshaveledtopersistentresistancetotheemergence
ofgenuineBSPs.
Inourexperience, this resistance isusuallydrivenbya fear
among potential players that BSP initiatives might actually
European payment service providers: A race to market and the nature of future victory?1
Julian Wakeham, Partner, CapcoAndrew Hogan, Managing Principal, CapcoHector Nelson, Consultant, Capco
1 ThisisarevisedversionofthearticlepublishedinInternationalPayments,
March2004
123
bringaboutmoreharmthanbenefit.Thereasonsandbarriers
for this are multiple. Firstly, many banks still consider their
technologyandoperationscapabilitiesasvaluablesourcesof
competitivedifferentiation.Inthebattleformarketsharethey
arereticenttoletgoofwhatarebelievedtobecoreassetsby
turningtoBusinessServiceProviders(BSPs)asanalternative.
These organizations have failed to recognize that in many
casesproprietaryinfrastructureisnotcoretotheirbusiness,
asitdoesnotsufficientlydifferentiatetheirofferings.Ifany-
thing, this somewhat antiquated mindset is increasingly
becomingacompetitivealbatross.Inourview,thepersistence
of financial institutions to remain infrastructure owners is
neither realistic nor viable, especially for small players. We
continue to advocate the point of view that, regardless of
governancestructure,thecustomerfranchisebusiness,prod-
uct innovationanddelivery,and infrastructureprovisionwill
needtobeunbundledasthepaymentslandscapeevolvesin
theyearstocome.
Secondly, banks have not yet overcome their reticence to
workcollaborativelywithcompetitorswhenitcomestoout-
sourcing non-core activities. Many players are concerned
about the loss of management control and ownership over
outsourcedactivities.However,alternativesexisttothesim-
plecustomer/providermodelandtheseallowmoreflexibility
intermsofgovernanceandcontrol. Indeedthegovernance
modelofaBSPcanofferaco-ownedorco-sourcedservice,
andassuchcanallowmanyproviderstooperateinanenvi-
ronmentofcooperation.Thesegovernanceoptionsprovidea
viablealternativetoanydominant-playercenteredmodels.
Thirdly, despite increasing cost pressures, the traditional
financial incentive to explore and develop alternative pay-
mentgovernancestructureshassimplynotbeensufficientto
inducewholesalebankstobeginthetransformationprocess.
Morerecently,bankshavecometorecognizeandappreciate
thatthecostsassociatedwithowningallthebusiness‘bun-
dles’describedabovearesuboptimal forallbut the largest
providers. Indeed,organizationsarestrugglingtocopewith
the overwhelming maintenance and development costs
requiredtokeepupwithindustrychanges,suchasCLS,T+1,
Basel II, and the E.U. pricing directive, to name but a few.
There are many examples of payments businesses where
maintenanceandsupportofexisting infrastructureexceeds
80percentoftheavailableITbudget.Banksareslowlycom-
ingtodigestthesecostimplications.
Finally,banks fear that therisks toqualityandcontrol that
are involved might outweigh the benefits of outsourcing.
Theyareafraid todelegateservices thatcould impactcus-
tomersatisfaction, thatSLAs in themselveswill notensure
qualityand that theywill lack theweight to influencedeci-
sions and manage the new interface as required. They are
afraid that the nature of BSP itself will impact quality and
customer satisfaction. Lack of exit options from the out-
sourcingmodeloncethedecisionhasbeenmademagnifies
thesefears.
ThelingeringresistancetoBSPsisbasedontraditionalbank-
ing perspectives on the dynamics of competitive markets.
However, it is the very nature of these dynamics that have
undergonesignificantchangeinrecentyears,particularlyin
theEuropeanpaymentsmarket.Thischangehasbeendriven
by regulators with an increasingly European and customer
protection outlook, challenging the historical balance
between regulation, competition, and cooperation that has
developed in each national market. As such, the change in
regulatorystancewillforcebankstore-thinktheirpayments
models,andconsequentlytheycompeteandcooperate.This,
combined with emerging standards, new technologies, and
increasedcompetitionwilldrivebanksto increasinglyques-
tionthevalueofkeepingpaymentprocessingcapabilitiesin-
house.Theemergenceofinfrastructuresthatunderminethe
valueoftraditionalcorrespondentrelationshipsand,forthe
smallerproviders,theinabilitytofollowtheircompetitorsto
low-cost offshore environments, will compound these argu-
ments. As such, the relationships between traditional com-
petitors are evolving toward more collaborative footings
whenappropriate.Theoldmarketparadigmsareslowlyfad-
ing away as value propositions are being redefined around
124 - The Journal of financial transformation
customers,costpressuresaremounting,and issuesaround
qualitystandardsofexternalpartnersarebeingredefined.
change is in the airAgainst this backdrop, we see the emergence of three pay-
mentBSPmodelsinthenottoodistanthorizon.Thecommon
themeacrossallthreeofthesemodelsiscustomer-centricity,
and if implementedcorrectly theywillhave thepotential to
liberateadimensionofvaluebeyondcostbenefitsandequity
participation.Acceleratedtop-linerevenuegrowthconstitutes
a third dimension of value, and is a direct outcome of the
markedincreaseinqualitythatwillcharacterizewinningBSP
modelsof the future.Higherqualitystandardswill translate
into higher degrees of customer loyalty, and ultimately cus-
tomer-spend, which will be achieved through improved spe-
cializationandmanagerialfocus.
Bank-centric model (Fi insourcing) — Many banks are
acknowledgingthebenefitsoffocusingonscalethroughcen-
tralization, shared services, and efficiency service offerings.
WeseethisinthecurrentmarketwithbothCitibankandABN
Amroaugmentingtheirrespectivepaymentsservicedelivery
tolargecorporatecustomersbycreatingutilities,accesspor-
tals, and support for exchange and marketplaces. Deutsche
Bankisalsoleadingthedevelopmentoffull-servicedistribu-
tion channels, leveraging their strong retail and wholesale
clientbases,aswellastheirabilitytomeetthedemandsfor
unified services across products and markets. These strate-
gies are allowing banks to solidify their market positions as
paymentssystemsbecomeincreasinglyinterconnected.
Joint venture model — Market forces are challenging the
traditional payment system continuum. Non-traditional pro-
vidersarechallengingincumbentsystemsandpaymentmar-
ketsareincreasinglyresponsivetopaymentprovidermodels
thatcombinethestrengthsofworld-classbankswithglobal
solutions and technology providers. The partial success of
AMS’sPROPONIXofferingisatestamenttothisfact.Thesuc-
cessof iPSL— theU.K.-based joint venturebetweenUnisys,
Barclay’s,LloydsTSB,andHSBC,whichseekstocreateeffi-
ciencies and cost reductions by managing routine business
functions—isyetanotherexample.iPSLnowhandlesnearly
70percentofallchecksprocessedintheUnitedKingdomand
istrulytransformingbusinessoperations,allofwhichdemon-
strates thatanumberofbankscancollaborate successfully
withalargetechnologypartner.
infrastructure-centric model—Theemergenceofnewpay-
ment infrastructure platform players — EBA Step 2/3,
VisaDirect,anddomesticplayerswithinternationalambitions
— is demonstrating a trend toward making payments both
moreregionallyorientedandcustomerfocused.Marketinitia-
tivesseekingtodrivecommonmessagingstandards—IBAN&
BIC, MT103, RosettaNet, and TWIST — are becoming more
prevalent,drivingautomation,andallowinginfrastructurepro-
viders to get closer to the end customer. Additionally, many
incumbentsare increasinglyenhancingtheirmarketproposi-
tionstooffervalue-addedservices,bothadvisoryandprocess-
ing.
developing a framework for successNewlyestablishedbusinessstrategiesareshiftingbanksfrom
‘infrastructure compliance’ to ‘business enhancement’ and
drivingtherealignmentofbankoperatingmodelstosupport
thistransformation.Higherservicelevelsandcostsavingsare
being achieved through cohesive sourcing strategies which
support a bank’s operating model through the utilization of
outsourcingandoffshoring.Theframeworkforsuccessthus
lies in developing the case for a BSP solution that demon-
strates substantial long-term benefit while simultaneously
beingviableintheshort-tomedium-term.Thebenefitmust
outweigh the implementation complexity and any related
downsidefromsocialandsystemupheaval.
Thus,beyondacompellingfinancialmodel,non-captiveBSPs
shouldadditionallybedesignedfromtheoutsettoprice ‘at
market’ratherthanbeacost-transfermechanismforincum-
bentinstitutions,haveagovernanceandconsequentlypric-
ing structure that support open and ubiquitous usage, and
fromtheoutsethavecredibility intermsofcapabilitiesand
125
longevity. Evenwiththesecriteriafullysatisfiedthereisafinalhurdle.
ThecomplexityofprovidingapaymentBSP lies inthecom-
plexityofthebroaderserviceproposition.Whilsttheunderly-
ing payment processes are commodity processes, the cus-
tomerservicelayerandsupportingtransactionconditionscan
createsignificantcomplexity.Thiscomplexity is,however,at
theheartofwhatcustomersvalueandthereforeformulates
an important dimension on which banks can differentiate
themselves from their competitors. BSP providers must be
able to either handle these complexities or allow their cus-
tomerbankstohandletheminmoreefficientways.
ThedynamicsofthepaymentsmarketinEuropeareevolving
at increasingly rapid rates.Customer, competitive, technical,
and regulatory pressures are forcing payment providers to
re-examine the basis on which they design and ultimately
deliver customer propositions. Traditional forms of gover-
nance and structure are being replaced with innovative
arrangements,ofteninvolvingeithercompetitorsturnedcol-
laboratorsornon-traditionalpaymentsplayers,orevenboth.
Standingstillandwatchingthesedevelopmentsfromtheside-
lines can no longer be a viable strategy for European pay-
ments providers. Understanding the nature of the changing
gameandpositioningforsuccessonthebasisofadisaggre-
gated value-chain has for many become the only feasible
means for long-term survival in the European payments
space.
Future
network-based payments and e-settlement
Harry leinonenAdviser to the Board, Financial Markets,
Bank of Finland1
Abstract
In order to increase the efficiency of payment systems the
opportunities of new technologies need to be employed.
IntegrationofcustomersICTsystemsandthoseofthebanks
need to be improved in particular. Internet technology pro-
videsnewpossibilitiesfordirectend-to-endcontactsbetween
all participants in the payment processing chain. Making an
e-paymentcouldbemadeaseasyassendingane-mail.This
articledescribesthestepsandchangesthatare, ingeneral,
necessary in order to transform national paper-based pay-
mentconventionsintointernationalnetwork-basedsolutions.
Wewillneedaninternationalaccountaddressingsystemand
anopennetworkbetweenserviceproviderstotransportwell-
standardized payment messages, including the inter-bank
settlement.
1271 Theviewsexpressedarethoseoftheauthoranddonotnecessarilyreflectthe
viewsoftheBankofFinland.
network-based payments and e-settlement
decentralized infrastructureThenetworkenvironmentisdecentralizedandtelecommuni-
cationbuildsbridgesbetweenthedifferent independentbut
interoperable entities in the network. With regards to pay-
ments,thesebridgesmusttransferpaymentmessagesaswell
as inter-bank settlements. This is the main difference with
other messaging systems. In a decentralized network-based
environmentthesettlementmethodalsoneedstobedecen-
tralizedinordertobeefficient.Inthisenvironment,thesettle-
mentmethodwillneedtoentailimmediatefinalitybetweenall
the different participating service-providing institutions
(mainlybanks).Thenewe-settlementmodel introducesnew
automated and electronic possibilities for inter-bank settle-
ments.E-settlementisaproposednewsettlementmethodfor
thenextgenerationofpaymentsystems,whichcannonethe-
lessbeemployednowincurrentpaymentsystems.
Theinter-banksettlementprocessitselfwillhavetobeawell-
integratedpartofthepaymentprocess,withend-to-endcon-
trolfromsendingtoreceivingbank.Inordertosupportrapid
paymenttransfers,thesettlementmethodmustalsosupport
real-timeprocessing.Anefficientsettlementsystemalsosup-
portscontinuousreconciliationforimmediateerrordetection.
Itisalsoimportantthatmostofthesecurityandcontrolfea-
turesbebuiltintothesystem,toenableimmediatereaction.
Thee-settlementprocessisdesignedtosupportandaccom-
plishfinalinter-banksettlementincentralbankmoneyinreal-
timeforend-to-endpaymentsinstraight-through-processing
(STP) mode. It should be seen as one essential part of the
wholepayment(credittransfer)circle(Figure3).
InFigure3, (1) thepayer receivesabill orother instruction
from thebeneficiaryconcerningapayment tobemade. (2)
Thepayerthensendstheinstructiontohisbankforprocess-
ingandroutingtothebeneficiary’sbank.(3)Thisinter-bank
leg includes e-settlement, so that the beneficiary’s bank
receivesboththepaymentmessageandthefinalsettlement.
(4)Thebeneficiary’sbankcantheninformthebeneficiaryas
totheincoming/finalpayment.
128 - The Journal of financial transformation 2 SeeforIBAN-informationThomsonFinancialPublishingwebpage:www.tfp.com/
payment.shtmlandtheEuropeanCommitteeforBankingStandards(ECBS)web-
page:www.ecbs.org
TcP/iP
internet-
network
Bank 1Payment/account
server
Bank 2Payment/account
server
Bank 3Payment/account
server
Bank nPayment/account
server
Payment
Payment
Payment
Payment
Figure1:Directinterbankcommunicationinanetwork-basedinfrastructure
Figure2a:Paymentscanbemadeby
transferringfundsbyaddressingdirect-
lythereceivingaccountinacommon
accountnumberspace.
Figure2b:Thecommonaccountnumber
spaceisdividedintosub-spacesbelong-
ingtoserviceproviderswhicharecon-
nectedviainteroperablesystembridges.
network-based payments and e-settlement
129
Current payments clearing conventions, although they now
use electronic automation, have evolved out of paper-based
physical processing and transportation. In order to further
increaseefficiencyandimproveservices,thepaymentsystems
needtobereengineered.Themaindriversforchangewillbe:
■ Thepossibilitiesofmodernnetwork-basedreal-timepro-
cessing.
■ Theneedforaclearanduniversalaccountnumbercon-
vention.
■ Thebenefitsofadirectdecentralizedinter-banksettle-
mentfacility,e-settlement.
Thenew technologyof telecommunications,mainly Internet
technology (TCP/IP) based networks, security facilities like
publickeyinfrastructure(PKI)andhardwaresecuremodules
(chipcardsorsecurePCcards),real-timeprocessing,lowcost
andefficientserverhardware,andmanyothersfactorswillbe
thebasisforthisreengineering.
connecting networksToday everybody is connected via networks. Using Internet
ande-mailwecansenddifferentkindsofmessages,invirtu-
ally real-time, to most of the bank employees in the world.
However,welackthesepossibilitiesforpaymentmessages.By
extendingthedecentralizednetworkconceptoftheInternet
topaymentsusingsecureanddedicatedTCP/IPnetworkslike
SWIFTnet,wecanbuildanewend-to-endandSTPpayment
processwithoutanyinterveningclearingandsortingcenters.
Thenetworksortsthepaymentsbytransportingthemtothe
given network address in the same way that an e-mail is
routedtothegivennetworkserver.Inthee-mailsystembanks
have e-mail/mailbox servers. In a network based payment
systemsbankswillneedpayment/accountservers,otherwise
theconceptisverysimilar.
international account number (iBAn)Inorder to routepaymentmessagesefficiently, innetwork-
basedsolutionsaswellasinanytraditionalsystem,weneed
auniversalaccountnumberconventionthatclearlyindicates
theaddressofanyaccountinthesystem.Thiscouldbecom-
paredtotheaddressofmailboxesontheInternetorinterna-
tional GSM telephone numbers for routing SMS messages
internationally(Figure2a).Aninternationalaccountnumber
(IBAN) seems to have become the preferred option. If all
banksimplementIBANsproperly,thecustomerwillonlyneed
tostatethecorrectIBANandthepaymentwillberoutedto
therightaccount.Thiswillrequirethesystemstohavesearch
tablesfromwhichtherightBIC,bankname,networkaddress,
etc.,canbefoundbasedontheIBAN.Thesekindsofmodules
andsearchtablesareemerging2.Withoutauniversalaccount
number-space,efficientcross-borderSTPcannotbereached.
Interoperablebridgesareneededtoroutepaymentsbetween
theaccountsofdifferentserviceproviders(Figure2b).
Payer’s bank Beneficiary’s bank
Payer Beneficiary
Figure3:E-settlementispartofthecredittransfercircle,whichprovides
efficientelectroniccommunicationsbetweenparticipantsinapayment.
4
2
3
1
including e-settlement
E-billing
E-banking
Bank-to-bank
Customer-to-customer
Customer-to-bank Bank-to-customer statementsreceipts
network-based payments and e-settlement
inter-bank networkAdedicatedinter-banknetworkisneededtolinktogetherall
participatingbanksandthecentralbank, forthepurposeof
processingpayments.Theinter-bankpaymentnetworkisthe
essentialpartofanetwork-basedpaymentsystem.Allbanks
canaddresseachotherdirectlyandsendpaymentstoeach
otherwithoutacentralizedprocessingandroutingsite.Thisis
theessentialnewparadigmintroducedbyInternetcommuni-
cations(TCP/IP-networks).Allparticipantscanoperate inde-
pendently; they only need enough networking capacity to
meettheirownneeds.Systemadministrationisneededonly
foradministrationpurposes,not,say,forpaymentprocessing.
ThenewSWIFTnetnetwork,introducedbySWIFT,isonethat
cansupportdirectcommunicationsbetweenallparticipants.
Therearealsonationaldedicatedpaymentnetworkswiththe
samecapability,suchastheinter-banknetworkPankkiverkko
inFinland.
immediate liquidityFor settlement purposes, banks need liquidity. Liquidity is
transferred by the central bank to the system (i.e. e-settle-
ment modules) at the start of the day. It can be increased
during thedayby thecentralbankvia liquidity transfersor
paymentstothebanks.Attheendoftheday,liquidityistrans-
ferredbacktothecentralbank.Theliquidityinthesettlement
modulesisthuscomposedofpositivebalancesofcentralbank
money,originally inthetraditionalformofreservedeposits,
intraday credits, etc., but transferred from the centralized
systeminthemorningtodistributede-settlementmodulesto
beemployedduringthedayinthee-settlementsystem.Inthe
eveningtheliquiditywillbetransferredbacktothecentralized
accounts for overnight bookings. When inter-bank payment
systems provide at some point in the future a 24hour/7day
service, as has been predicted, the e-settlement modules
couldstarttoruncontinuouslybyonlyreportingthebalance
attheturnofaccountingday.
Inatruereal-timeenvironment,thereisgenerallylittlescope
for the various types of liquidity saving features, based on
delayingorqueuingofpayments.Customersarewaitingfor
direct confirmation of their payments. A bank that is often
obliged to inform its customers that payments are queued,
thatitiswaitingforliquidity,willlosecustomers.Inthereal-
timeenvironment,customersexpectdirectdelivery.
Still, the e-settlement module could contain basic queuing
facilities for situations in which the available liquidity is not
sufficient or customers are willing to accept delays. These
wouldbedecentralizedqueues,designedfordifferent levels
ofcomplexity.Bilateralnettingcouldbeaccomplishedinthe
distributed e-settlement system through bilateral netting
requeststocheckwhethertherearetransactionsalsoqueued
at the other end. Multilateral netting requires a centralized
nettingagent.Differenttypesofnettingandadvancedliquid-
ity saving featureswouldcomplicate thesystem. It isadvis-
able to keep the basic system very simple; possible add-on
servicesshouldbeprovidedseparately.
High security and availabilityThe system's security features must be carefully designed.
The settlement balance and all security keys need to be in
tamper-resistant environments and all the encryption algo-
rithmsmustbehighlyreliable.Thereshouldbenopossibility
ofsystemintrusion,andanytypeofhackingshouldbeimme-
diatelydetectable.Thesystemwillbeclosed,withsettlement
money circulating among a limited number of trustworthy
users. The system will include automated reconciliation at
end-of-day,fromtimetotimeduringtheday,andinconnec-
tionwitheachtransaction. Inanetwork-basedenvironment,
allparts,centralizedanddistributed,mustbewellsecured.A
digital/electronicversionofthefour-eyesprinciplehastobe
implemented.
Twodifferentcontrollingprogramsandtwodifferentencrypt-
ed and tamper-resistant storage devices protect the money
balances. The separate controlling functions are monitoring
each other so that there are no individual IT developers or
developmentteamsthathaveallthenecessaryprogramming
code in their possession. In case of intrusion attempts, all
criticalinformationwillbedestroyedatthatsiteandtherewill
130
network-based payments and e-settlement
Thiscredit-push/credit-transfer typeofpayment is themost
convenientandefficientinthenetworkreal-timeworld.Ithas
fewer processing and transportation legs than electronic
credit/debitcardpayments,directdebits,orelectronicchecks.
In credit transfers, the payer’s bank identifies its customer,
checks the payment instruction, and debits the payer’s
account; the beneficiary’s bank checks the settlement and
creditsthebeneficiary’saccount.Inthefuturereal-timeworld,
paymentswillbeprocessedwithinsecondsinthesamewayas
e-mailandSMS-messagesarenowprocessed.
An e-settlement solutionThee-settlementsolutionshouldbeseenaspartofthefuture
paymentinfrastructurethatwillsupportanincreaseine-com-
merceviatheInternet,real-timesecurityandmoneymarket
deals and transfers, mobile payments (currently GSM-based
butsoonUMTS-based),andcross-bordervolumes.
Thepaymentworld(forallkindofpayments)willbechanging,
aswillallothermessagingsystems,fromslower-pacedbatch
processingtoimmediatereal-timeservice,integrateddirectly
withusersystemsinaglobalnetworkcommunity.
E-settlementprovidesasolutionthatcanbeintegratedinto
currentsystems,usingapartof theexisting infrastructure,
andhenceitfacilitatesagradualchangefromcurrentstruc-
turestonewe-basedones.Thefundamentalideaofe-settle-
ment is attachment of a digital e-settlement stamp to the
currentpaymentmessages.Thee-settlementstampisadded
tothepaymentmessageandservestotransfercentralbank
moneyfrompayer’sbanktobeneficiary’s.Finalsettlementis
part of the payment message, in the form of an electronic
centralbankdraftorcentralbanke-cashforinter-bankset-
tlementpurposes.Theelectronicstampwillaccompanythe
payment on its route through the inter-bank payment net-
worktothereceivingbank.Theelectronicstampcanbeseen
asamodernversionofacentralbankdraft.Itisthecoverin
centralbankmoneyofthepayment(s)itaccompanies.
The stamp is protected by very strong and modern crypto-
graphictechnology(e.g.,PKI).Thesestampsareproducedand
decoded by e-settlement modules situated close to banks’
paymentsystems.
The e-settlement modules are tamper-resistant devices pro-
vided by central banks to each bank. These are closely inte-
grated with banks’ payment systems, for example, directly
integrated with the SWIFTnet access platform (CBT). This
makes settlement transfers a highly automated part of pay-
mentprocessing. Integratingthenewsettlementprocesswill
be quite straightforward, given that it will be done on the
access platform (e.g., SWIFT CBT) level. In traditional RTGS
systems,banks’settlementaccountsarelocatedinthecentral-
ized RTGS system. In the e-settlement system, each bank’s
settlementaccountisdistributedtothebank’sownprocessing
site in a central bank controlled e-settlement module. This
moduleshouldberegardedasacompletelyautomatedcentral
bank branch serving one customer with one account. Each
bank has access to its own account, as before, but is much
morecloselyintegratedinamoreautomatedandefficientway.
Thedistributionofcentralbankmoneyinelectronicformatto
banks’ payment platforms is the essential feature of the
e-settlementapproach.Thedistributinge-settlementmodules
needtobehighlysecureandneedtomeetatleastthesame
security standards as do traditional RTGS systems. The sys-
temshouldalsobegenerallyopenand independent,tosup-
portthevariouspaymentnetworksusedbybanks.
131
network-based payments and e-settlement
beasecurityalerttothesystemadministrator(s).
Highavailabilitymustalsobeensuredinthedistributedsys-
tem. In a distributed system, a malfunction will generally
affectonlyoneparticipantatatimeandonlythosepayments
toandfromthatparticularparticipant. Inorderforthepar-
ticipanttoreestablishnormaloperationsquickly,thereshould
beback-upsandmirroreddevicesforallcriticalcomponents.
Redundantinformationinthee-stampsgivesthepossibilityto
parsetheinformationofcompletelydestroyedIT-sites.Italso
supports a direct switch of functionalities and services to
workingpartsofthenetwork.Thismakesdistributedsystems
morerobustthantraditionalcentralizedsystems.
The benefitsThemainbenefitofe-settlementisthatitenablesredesignof
thewholepaymentsystemprocessinanefficientway,using
newnetworkpossibilities.Ittherebycreatesthenextgenera-
tionofpaymentsystemsinfrastructuresandmakesthesettle-
ment process more efficient. Payment systems will change
considerablyinthenearfutureduetomoderntechnologyand
itwouldbeanadvantage tomodernize the settlementcon-
ventionsatthesametime.
Thedecentralizednetwork-basedmodelfacilitatesdirectreal-
time communication. General standards will result in a STP
process.Thebestexampleisthecurrente-mailsystemandits
standards.Theseareappliedworldwideandgiveareallylow
cost, efficient, and rapid communication system. The e-mail
costs are so low that they are considered to be part of the
generaloverhead;nobodybotherstoreportthemseparately.
Thesametypeof infrastructurewithadditionalsecurityele-
mentsandthesettlementfunctioncouldbedevelopedforthe
paymentsector.
Thecost-advantageofthee-settlementsystemis inthe low
processing costs of adding the e-settlement stamp that
enables instant final settlement in central bank money. The
extraprocessingcostofaddingthee-settlementstampwillbe
practicallyzero.Itwillbeanintegralpartofthepaymentpro-
cessitself.Banksneedonlyinvestinlowcostequipment.The
verylowtransactioncostsofe-settlementwillenablebanksto
alsotransferpaymentflowsfromcentralizedprocessingcen-
ter systems to more efficient decentralized network-based
communications.
The bottlenecks created by centralized resources will disap-
pearandeventhedependenceoncriticalcentralizedresourc-
es will be dramatically reduced. E-settlement could offer a
solutionforintegratingtheeuro-zoneareapaymentsystems,
andamulti-currencyversioncouldserveanevenlargerarea.
Inorder toachieve large-scalebenefitsvia thee-settlement
model, the number of participating banks and the payment
flowsmustbesufficientlylarge.
The e-settlement approach will also reduce settlement risk,
becauseallsettlementsaredoneincentralbankmoneywith
immediatefinality.Thereconciliationandcontrolfunctionsin
thesystemwillalsoreducethepossibilityforerrorsoratleast
speeduptheprocessforfindingthem.Ingeneraldecentral-
izedsystemsaremorerobustthancentralizedsystems.
1323 TheresultsoftheprototypeprojectarepresentedattheBankofFinland’sweb
sitewww.bof.fi/sc/e-settlementandinLeinonen,H.,V-M.Lumiala,andR.Sarlin,
2002,“Settlementinmodernnetwork-basedpaymentinfrastructures–description
andprototypeofthee-settlementmodel,”theBankofFinlandpublicationDP23.
Furtherinformationaboutdevelopmentsinpaymentsysteminfrastructurescanbe
foundinLeinonen,H.,2000,“Re-engineeringPaymentSystemsfortheE-world,”
theBankofFinlandpublicationDP17,andinPaymentSystemsWorldwidemaga-
zine,SpringandSummer2000issues.
Future
Banks’ strategies for payment services: which role for debit cards?
Francesco saitaAssociate Professor, Financial Markets and
Institutions Department, università Bocconi
Abstract
Debitcards’role,eitherusedatATMsoratmerchants’point-
of-sale, in payment services provisions by banks has been
studied by many researchers before the development of
Internetbanking.Yet,byanalyzingdataonrecentevolutionof
debitcards’diffusionandusageacrossmajorcountries,debit
cardsshowinterestingevolutionpatterns.Istherestillarole
fordebitcardsinbanks’strategiesonpaymentsystems?This
paperdiscusses thisproblembyanalyzingwhybanksmight
invest indebitcards’developmentandexaminingwhichfac-
torsinpracticemaymakethemverycautiousindoingso.
133
1 Bansal,P.,2002,“KeepYourCostsDown,”TheBanker,March,125
2 Bansal,P.2002,“Multi-mediaDifficulties,”TheBanker,March,124.
Banks’ strategies for payment services: which role for debit cards?
newchannelwasslowerthananticipatedandthat itsshort-
termbenefitsforbanks’P&Lshadoftenbeenoverstated.This
hasalsoledsomebankstoconsider,withmuchmorecaution,
investments in new alternative distribution channels, recon-
sidering the benefits deriving from the traditional branch
networks2.Thiscaution,andsometimesthedisenchantment,
aboutnewchannelsalsohasan impacton thestrategies in
thepaymentbusinessandon thewillingness topursueand
introduceinnovationsinthefield.
Inthispaper,Iaimtodiscusstheroleofdebitcardstosupport
abank’sstrategyinthepaymentservicesbusiness.Therea-
sonwhythiscouldbeinterestingisthatwhiletheyhavebeen
amajordriverforchangeandwereatthecenterofthedebate
abouttechnologicalinnovationbeforethebirthoftelephone
andInternetchannels,theirpopularityamongbankmanagers
has fallen in recent years. While telephone and especially
Internet banking were attracting major attention and by far
the largest share of banks’ investments in new distribution
channels,debitcards,togetherwithATMsandPOSterminals,
onlyremainedinthebackground.Atpresent,then,afterreal-
izing that thee-commercegrowthwascertainlynotaspro-
foundasmanyhadthought,andthatasubstantialpartofin-
storepaymentscannotbesubstitutedbypayments through
theInternet,itispossibletohaveadebateaboutwhether,and
uptowhatextent,debitcardsmaystillrepresentasignificant
opportunityforbanksinthepaymentservicesarena.
134 - The Journal of financial transformation
cards with a cash function cards with a debit function cards with a credit function cards with an e-money function
2001 2002 2001 2002 2001 2002 2001 2002
Belgium 1361 1442 1217 1306 296 294 778 800
Canada Nav nav Nav nav 1510 1653 2 2
France 711 741.5 652 684 Nav Nav 5 14
Germany 1480 1443 1252 1129 381 391 818 819
Italy 429 477 404 459 345 375 1 5
Japan* 2554 2603 Nav Nav 1820 1919 Nav Nav
Netherlands* 1608 1635 1315 1338 312 316 1309 1078
Sweden* 536 643 542 549 419 472 63 55
Switzerland 1191 1232 745 789 452 454 485 502
u.K. 2247 2400 920 1004 951 1066 nav nav
u.S.A. 2886 2996 888 902 4322 4355 nav nav
*Dataoncardswithacreditfunctionincludecardswithadelayeddebitfunction.
Figure1:Numberofcardsperthousandinhabitants
Source:CommitteeonPaymentandSettlementSystems(CPSS),RedBookStatisticalUpdate,March2004.
Banks’ strategies for payment services: which role for debit cards?
135
Retail payment services have always been important for
banks,notonlybecausethesupplyofpaymentserviceshas
been fundamental in their development in the Middle-Ages,
butalsobecausepaymentservicescurrentlyrepresentabusi-
ness area with a substantial impact on banks’ profitability.
Accordingtoa2002studybyBostonConsultingGroup, the
payment business accounts for up to 35% of revenues and
40%ofcostsforbanks1.Asaconsequence,manybankshave
overtimedevotedsignificanteffortandinvestmentinorderto
increase revenues and reduce costs deriving from the pay-
ment business. The development of new channels, such as
ATMs, POS terminals, telephone, and Internet banking, has
representedaclearopportunitytopursuethoseobjectives.
Atthesametime,newchannelsdidnotalwaysfulfilltheper-
hapswishfulandoptimisticexpectationsof increasedprofit-
abilitythathadbeenformulatedexante.Aftertheendofthe
period of over-enthusiasm about Internet banking, many
observersagreedthat thedevelopmentof the Internetasa
cAgR of ATms
per country,
1998 2000 2002 1998-2002
CPSS average 648 794 927 9.4%
u.S. 677 967 1220 15.9%
u.K. 421 563 690 13.1%
Switzerland 642 675 706 2.4%
Sweden 281 295 297 1.4%
Netherlands 418 435 466 2.8%
Japan 934 922 895 -1.1%
Italy 487 549 683 8.8%
Germany 556 580 612 2.4%
France 490 580 637 6.8%
Canada 778 1037 1272 13.1%
Belgium 564 657 683 4.9%
Figure2:NumberofATMspermillioninhabitants
Source:CommitteeonPaymentandSettlementSystems,RedBookStatistical
Update,March2004.
Note:CPSSaverageisaweightedaverageofthecountriesincludedinthe
CommitteeonPaymentandSettlementSystemsstudy,andalsocomprises
SingaporeandHongKong.
cAgR of Pos
terminals per
country,
1998 2000 2002 1998-2002
CPSS average 6136 10862 12040 18.4%
u.S.A. 6157 10976 12128 18.5%
u.K. 10462 12533 13691 7.0%
Switzerland 7158 9369 10976 11.3%
Sweden 8406 9822 11439 8.0%
Netherlands 8533 9774 10972 6.5%
Italy 6001 9878 14109 23.8%
Germany 4423 7194 5584 6.0%
France 12047 13848 15620 6.7%
Canada 13024 14231 15737 4.8%
Belgium 9121 11346 13136 9.5%
Figure3:NumberofPOSterminalsformillioninhabitants
Source:CommitteeonPaymentandSettlementSystems,RedBookStatistical
Update,March2004.
Note:dataforJapanareunavailable
cAgR
1998 2000 2002 1998-2002
CPSS average 25.4 28.4 25.6 0.2%
u.S. 40.6 45.3 36.7 -2.5%
u.K. 31.7 34.5 38.3 4.8%
Switzerland 11.3 18 21.5 17.4%
Sweden 37.6 36.2 36 -1.1%
Netherlands 27.1 29.5 29.7 2.3%
Japan 3.1 3.2 2.9 -1.7%
Italy 8.5 9.1 10.9 6.4%
Germany 17.1 20.4 19.7 3.6%
France 15.5 17.9 19.8 6.3%
Canada 47.5 48.4 45.6 -1.0%
Belgium 15.6 19.8 23 10.2%
Figure4:NumberoftransactionsatATMsperinhabitant
Source:CommitteeonPaymentandSettlementSystems,RedBookStatistical
Update,March2004.
Banks’ strategies for payment services: which role for debit cards?
possibletoseethatthedispersionacrosscountrieshaseven
increasedbetween1998and2002,especiallyduetothestrik-
ingly high growth rates of ATM terminals in the U.S. and
Canadainparticular,thathavebeenreplicatedinEuropeonly
bytheUnitedKingdom.Inanycase,allcountriesexceptJapan
show a clear tendency to an increase in the availability of
terminals;overall, thenumberofATMsinthecountriescov-
eredbytheCommitteeonPaymentandSettlementSystems
reportin2002was40%higherthanfouryearsbefore.
ThepictureconcerningtheavailabilityofPOSterminalsalso
shows clear differences between countries, even if in this
case differences seem to be smaller and many European
countries appear to be in leading positions. Among those,
particularlyremarkableisItaly’scompoundedannualgrowth
rate of 23.8%, with POS terminals more than doubling
between1998and2002.
WhilethedatainFigures1,2,and3seemtoprovideaclear
overallpictureofthecountrieswherecardshaveamajorrole,
it isinterestingtolookcarefullyatthedataconcerningcard
usage(Figures4and5).ForATMs,whileCanada,U.K.,andthe
U.S.areamongthecountrieswithmoreATMsperinhabitant
and have a higher usage rate, variations in the number of
transactionspercapitaaremuch lowerthanchanges in the
numberofavailableterminals.Theoppositehappensinstead
forPOStransactions.Asaresult,bycombiningthedata,itis
possible to assess that while ATM productivity in terms of
number of transactions per terminal has generally been
decreasing (with the remarkable exception of Switzerland),
POS terminals have continued to face a significant growth
(Figures6and7).
ByobservingthedatainFigure6and7therearemanyinter-
esting elements that emerge. First of all, the two countries
thatexperiencedthehighestgrowthinATMtransactionsper
inhabitant,SwitzerlandandBelgium,didnotattainthisobjec-
tivethrougharemarkableincreaseinthenumberofavailable
terminals, but by simply increasing their productivity. This
suggeststhatinvestmentoncustomereducationorappropri-
atepricingstrategiesmaybemoreeffectivethanaggressive
strategiesconcerningthenumberofavailableterminals.Itis
alsoworthnotingthatthecountrieswiththemostremarkable
growthinthenumberofATMspermillioninhabitants(Canada,
U.K.,andtheU.S.)notonlyexperiencedasubstantialdecrease
in ATM productivity, but in two cases also registered a net
decreaseinthenumberoftransactionsperinhabitant.
Data on POS productivity are different, since all countries
experiencedsuchasignificantgrowthinthenumberoftrans-
actions per inhabitant that productivity increased every-
where. There is also a positive correlation between the
growthintheterminalsnetworkandthegrowthinthenum-
beroftransactionsper inhabitant(asopposedtothenega-
tive correlation that existed for ATMs). Yet, expanding the
POS network is clearly not the only way to increase debit
cardstransactions:ItalyandSwedenexperiencedthehighest
growthintransactionperinhabitant,butSweden’sgrowthin
thenumberofterminalswasonlyaround30percent.Atthe
sametime,Italyitselfnowhasaterminalbaseperinhabitant
higherthanallotherEuropeancountriesexceptFrance,and
yettheproductivityofitsterminalsislowerthan25%ofthe
136 - The Journal of financial transformation
cAgR
1998 2000 2002 1998-2002
CPSS average 18.3 27.2 39.1 20.9%
u.S. 20.8 33.8 54 26.9%
u.K. 30.3 40.7 51.7 14.3%
Switzerland 14.9 23.9 30.8 19.9%
Sweden 18.1 28.9 57.1 33.3%
Netherlands 37.9 50.3 66.2 15.0%
Italy 3 5.5 9.5 33.4%
Germany 8.2 12.7 16.7 19.5%
France 43 54.3 66.9 11.7%
Canada 44.8 63.7 76.4 14.3%
Belgium 29.1 39.8 52.1 15.7%
Figure5:NumberoftransactionsatPOSterminalsperinhabitant
Source:CommitteeonPaymentandSettlementSystems,RedBookStatistical
Update,March2004.
Banks’ strategies for payment services: which role for debit cards?
Ofcourse,whendiscussingthistopicwemustconsiderthat
thediffusionandusageofcardsismarkedlydifferentacross
countries,andsoisobviouslythepotentialforimprovement.
Forthisreason,wewillstartbyanalyzingdataconcerningthe
penetrationofcards,theavailabilityofterminals,andcards’
usageacrossmajorcountries.Wewillthendiscussthepoten-
tialbenefitsbanksmayexpectfromneweffortsincards’dif-
fusion and examine the obstacles that might prevent banks
frominvestingsignificantlyinthedebitcardbusiness.
debit cards diffusion and usage across countries: Key data and trendsThediffusionofcardsacrossdifferentcountriesis,asonemay
expect,significantlydifferent,duetoanumberofreasonsthat
arelinkedpartlytostructuralcharacteristicsofthefinancial
system (i.e. different households’ attitude towards financing
purchases with debt that may help explain differences in
credit cardsdiffusionandusageacrosscountries), partly to
the history of the banking system (i.e. the development of
alternative competing ATM networks that may require the
customertoholdmultipledebitcards,orthedevelopmentof
auniquenationalATMnetwork),andpartlytothecharacter-
isticsofretaildistributionnetworkofgoodsandnon-financial
services(sincethe levelofconcentration, the importanceof
big distribution networks, and the average size of retailers’
facilitiesmayimpactthespeedofadoptionofnewmeansof
payment). The overall recent picture of cards’ diffusion is
reported in Figure 1, where it is possible to note that while
there is a huge difference, as far as credit cards are con-
cerned, between Japan and Anglo-Saxon countries on one
sideandremainingEuropeancountriesontheother,thesitu-
ationissomewhatmoremixedasfarasdebitcardsarecon-
cerned, where countries such as Netherlands, Belgium and
Germanyhaveaclearleadingposition.
Asforcards’diffusion,eventhenumberofterminalsavailable
forcardusageismarkedlydifferentacrossmarkets.Figure2
reportsthenumberofATMspermillioninhabitants,anditis
137
Transactions per terminal Var% Terminals Trans-
cAgR actions/
inhabitant
1998- 1998- cAgR
1998 2000 2002 2002 2002 1998-2002
Belgium 27,660 30,137 33,675 21.7% 4.9% 10.2%
Canada 61,054 46,673 35,849 -41.3% 13.1% -1.0%
France 31,633 30,862 31,083 -1.7% 6.8% 6.3%
Germany 30,755 35,172 32,190 4.7% 2.4% 3.6%
Italy 17,454 16,576 15,959 -8.6% 8.8% 6.4%
Japan 3,319 3,471 3,240 -2.4% -1.1% -1.7%
Netherlands 64,833 67,816 63,734 -1.7% 2.8% 2.3%
Sweden 133,808 122,712 121,212 -9.4% 1.4% -1.1%
Switzerland 17,601 26,667 30,453 73.0% 2.4% 17.4%
u.K. 75,297 61,279 55,507 -26.3% 13.1% 4.8%
u.S.A. 59,970 46,846 30,082 -49.8% 15.9% -2.5%
CPSS average 39,198 35,768 27,616 -29.5% 9.4% 0.2%
Figure6:ProductivityofATMterminals
Source:ElaborationondatafromCPSS,RedBookStatisticalUpdate,March2004.
Transactions per terminal Var% Terminals Trans-
cAgR actions/
inhabitant
1998- 1998- cAgR
1998 2000 2002 2002 2002 1998-2002
Belgium 3,190 3,508 3,966 24,3% 9,5% 15,7%
Canada 3,440 4,476 4,855 41,1% 4,8% 14,3%
France 3,569 3,921 4,283 20,0% 6,7% 11,7%
Germany 1,854 1,765 2,991 61,3% 6,0% 19,5%
Italy 500 557 673 34,7% 23,8% 33,4%
Japan nav nav nav nav nav nav
Netherlands 4,442 5,146 6,034 35,8% 6,5% 15,0%
Sweden 2,153 2,942 4,992 131,8% 8,0% 33,3%
Switzerland 2,082 2,551 2,806 34,8% 11,3% 19,9%
u.K. 2,896 3,247 3,776 30,4% 7,0% 14,3%
u.S.A. 3,378 3,079 4,453 31,8% 18,5% 26,9%
CPSS average 2,982 2,504 3,248 8,9% 18,4% 20,9%
Figure7:ProductivityofPOSterminals
Source:ElaborationondatafromCPSS,RedBookStatisticalUpdate,March2004.
3 Feescanalsobelessevidentincaseswhenthecustomerischargedbythebank
alsoonthebasisofthenumberoftransactionsonhisbankaccount,orthenum-
beroftransactionsoveracertainthreshold.Inthiscaseacustomerthatuseshis
debitcardfiveorsixtimesatPOSterminalsinsteadofwithdrawingcashonceand
payingthemerchantsincashisclearlygeneratingahigheramountoffeesforthe
bank,evenifheprobablydoesnotperceivethedebitcardascostly.
4 Atkins,W.,2004,“IsDebittheNewCash?”TheBanker,June,110-111
Banks’ strategies for payment services: which role for debit cards?
may complete autonomously through an ATM instead of
entering the branch could further reduce the workload for
branches.DebitcardandATMsupportersarguethatwhilea
significant cost saving may already have been attained by
mostbanks,a furtherdevelopmentof self-service terminals
eveninsidethebranchmaybefundamentaltokeeptheover-
allcostsofabank’sdistributionnetworksufficientlylowand
toletthebranchberestructuredsoastomaximizeitsselling
potential. On the other hand, however, multifunction ATMs
couldbeusedtodeliverothernon-bankingservices(i.e.pur-
chasing tickets forentertainmentorsportevents) thatmay
produceextrarevenuesforthebankandhelpamortizingthe
costsofitsATMdistributionnetwork.Insomecases,develop-
ingtheseservicesmayalsoprovidecustomersanincentiveto
get more familiar with ATMs. In Italy, for example, banks
started offering customers the opportunity to conveniently
rechargetheprepaidcardsformobilephonesthroughATMs.
Consideringtheextremelyhighdiffusionofcellularphonesin
Italy, thishasbeenasignificantsource fornew incomeand
theopportunitytomakedebitcardsanormalinstrumentfor
a largeshareofcustomersthathaduntil thenprovedtobe
resistanttoalltheeffortsdevotedtoincreasecardusage.
Developmentsine-commercecouldalsohelptoincreasethe
usageofdebitcard,iftheycanalsobecomeasafemeansof
payment for purchases through the net. This could become
possibleifandwhenlow-costcardreadersbecomeavailable,
sothatthebuyerscanusePIN-basedpaymentsconfirmation,
ratherthanhavingtosendtheircarddetailsthroughthenet.
Of course similar card readers could be designed for both
credit and debit cards, which makes determination of their
impactondebitcardusagelesscertain.Thisisnot,however,
somethingthatmayattractbanks’ interestintheveryshort
term,sincethedevelopmentofcheapreadersisatechnologi-
calpreconditionforanyeffortinthisdirection.
what may prevent banks from investing in debit cards?While there are many good reasons why we should expect
bankstospendtimeandeffortinincreasingdebitcarddiffu-
sionandusage,a realisticanalysismustalsocarefullycon-
sider theobstaclesand thedoubts thatmaypreventbanks
fromdoingthat,or,atleast,frominvestingattheratetech-
nology suppliers and innovation supporters would like. The
reasons behind banks’ caution are various, sometimes
extremely well grounded and sometimes purely psychologi-
cal.However,theymustclearlybeconsideredifonewantsto
realistically evaluate the potential for further debit card
expansion.Forclarity,wecangroupthecausesforresistance
intotwodifferentareas,theuncertaintyabouttheattainable
returnoninvestmentsondebitcardsinparticularandonthe
payment business in general, and the (at least perceived)
unsatisfyingperformanceofrecentinvestmentsonnewtech-
nologicalchannels,suchasInternetandPCbanking.
Firstofall, it isverydifficulttoassessthereturnoninvest-
mentfromalternativechannelsprecisely.Whileforinstance
theextrarevenuesgeneratedbyincreaseddebitcardusage
atPOS terminalsmaybeeasy toassess, thepotential cost
savingsderivedfromareductionintheamountofcashbeing
handledbythebankareclearlymuchmorecomplextoquan-
tify.Consequently,whileitmaybeeasytodescribeintheory
thatthismaybeanadvantageabankshouldconsiderwhen
deciding whether and how to promote higher card usage
rates, theuncertaintyabout thesavingsthatcouldactually
beattainedisaclearobstacle.Abankwouldliketobeableto
fullyevaluatetheoveralleconomicconsequencesofeitheran
aggressivepricingstrategyoramarketingcampaignamong
customers before undertaking them, and the difficulties in
understandingtheimpactoninternalcostsisfromthisview-
point a major problem. This problem is common to other
channelsaswell,atypicalexamplebeingtheInternetwhere
evenaclearassessmentofincrementalrevenuesmaybedif-
ficult, since it is not always clear whether a product pur-
chasedon-lineisarealnewpurchaseorsimplyasubstitute
forapurchasethatthecustomerwouldhavemadethrough
moretraditionalchannels.
The problem of evaluating real attainable cost savings is
equally important when critically assessing the benefits of
138
Banks’ strategies for payment services: which role for debit cards?
productivityofthesecondworstcountryreported;theresult
isnotexplainedbyalowernumberofdebitcardseither(from
Figure1itispossibletoseethatforthenumberofdebitcards
per thousand inhabitants it is close to countries such as
Sweden and France with a completely different number of
transactionsperterminal).Whiledifferencesinterminalpro-
ductivitymaydependalsoonthestructureofretailers’distri-
bution network across different countries, it is quite clear
thateffortsdevotedtoincreasecardusageratherthansim-
plyincreasethenumberofcardsincirculationorthenumber
ofavailableterminalsmaybeimportant.Ofcourse,providing
incentives to customers to increase card usage by either
adopting aggressive pricing strategies or developing cam-
paignstopersuadethemtograduallychangetheirbehavior
requiresasignificantcommitment. Iwillnowbrieflydiscuss
whyweshouldexpectbankstoseriouslyconsiderinvestingin
thisdirectionandwhich,at thesametime,are thereasons
whytheymaystillbeverycautiousandreluctanttodothat.
why should banks invest to develop debit cards further?Theheterogeneouspictureemergingsuggests that in some
countries there are still large margins for improvement in
termsofdebitcards’diffusionandusage.Whilethepotential
fordebitcards’ furtherdevelopment is testifiedbystillhigh
growthrates inthenumberoftransactionsand isobviously
stressedbynewtechnologysuppliersorbynetworkssuchas
MasterCardorVISA,itisimportanttodiscusswhichbenefits
banksmayactuallyexpectfromfurtherinvestmentsondebit
cards.
Asfaraspotentialbenefitsareconcerned,wecouldconsider
thebenefitsderivingfromgreaterusageatthepoint-of-sales
terminals.Inthiscase,benefitsforthebankmayderivefrom
thefeesthatcanbechargedtocustomers,ifafeeischarged,
and merchants. In any case, direct charges on debit cards
usagewouldclearlybecounterproductiveonthenumberof
transactions3whenrevenuesfrommerchantsdependonthe
marketsharethebankhasamongmerchantsonly(sothat,for
instance, a bank with a large retail customer base but few
merchantshasfromthisviewpointlittleincentivetoinvestto
convinceitscustomerstoincreasecardusage).Agreateruse
ofdebitcardsatPOSterminalsmayalsoimplyareductionin
the costs a bank faces for handling cash, and moving it
betweenbranchesandautomatedtellersinordertomakeit
availabletoitscustomers.Someanalystssuggestthatifmer-
chants’feeswerebasedontherealcoststhebanksbears,the
threshold where debit cards would become a cheaper pay-
menttypeformerchantsthancashwoulddroptoalevelas
low as U.S.$124. While there may be uncertainty about the
exactcostestimatesthatmayhelpidentifythethresholdpre-
cisely, pricing is undoubtedly a critical issue for providing
banks,merchants,andcustomerstherightincentivestosub-
stitutecashwithmoreefficientmeansofpayment.
ApartfromdebitcardusageatPOSterminal,banksmaybe
willingtodevelopusageatautomatedtellersalso,fordiffer-
ent reasons. Increasing the number of cash withdrawals,
request for information, and bill payments that customers
1395 FernandezCaro,S.,2002,“MoreEffortGoesintoBranches,”TheBanker,August
6 Bielski,L.,2003,“HardtoGettheOnlineHabit,”ABABankingJournal,February,
79-86
Banks’ strategies for payment services: which role for debit cards?
adequately exploiting this unutilized potential first, rather
than increasing the capacity of other alternative channels
suchas,forinstance,ATMs.Thisisreinforcedbythefactthat
PCandInternetbankingmay,firstly,provideevengreatercost
savings for lowvalue-added transactions, suchasabalance
enquiryorsimplebanktransfers6,andsecondly,offertothe
bankcheaperandricherinformationonthecustomer’strans-
actionsandinterests,whichcouldleadtobettersellingoppor-
tunities. Suggesting new products through the website and
providingfastandadequateinformationontheircharacteris-
ticsispossiblethroughInternetandPCbanking,butitisbasi-
callyimpossiblethroughATMs.Thepayoffbanksmayexpect
from trying to exploit the potential of their previous invest-
mentsonInternettechnology,evenifofcoursetheneedfor
upgradesisevenanissuehere,isthereforesubstantiallydif-
ferentfromtheonethatmaybederivedbyoldertechnologi-
calchannels.
Thesecond implicationofthepoorresultof Internet invest-
mentshasprobablybeentoincreasetopmanagers’riskaver-
sionwhenevaluating investments indistribution technology
ingeneral,especiallyconsideringthedifficultiesfacedinprop-
erlymeasuring,evenexpost,returnsoninvestment.Itmaybe
hardfortheheadofaretailbankingdivisiontopersuadethe
chiefexecutiveofficerthatdespiterecentunfortunateresults,
investing in new channels may be a winning choice for the
bank.Itismorelikelyinsteadtoassumethatabankmayreact
to unsatisfying Internet investments returns by reducing
investments in the retailbankingdivision in favorofothers,
andconcentrateretailbanking investmentsonrestructuring
traditional bank branches that have been proven to be far
moreimportanttocustomersthanmanyInternetsupporters
wouldhavepredictedafewyearsago.
conclusionsDebitcardsthathadbeenforalongtimeconsideredtobea
key innovation inbanks’distributionnetworks—priortothe
adventoftelephone,Internet,andPCbankingchannels—con-
tinue to experience significant growth, especially as far as
usage at POS terminals is concerned, and still represent an
importanttoolforabank’sstrategyintheretailbankingbusi-
ness.Yet,banks’investmentsinthefieldmaybelimitedbythe
difficulties inclearlyunderstandingchannelprofitabilityand
theactualcostsavingsthatmayderivefromincreaseddebit
cardusage. Ifprofitability isnotcompletelyclearandatthe
sametimedebitcardsarenolongerperceivedasasourceof
differentiation,sinceinnovationismainlydrivenbytechnolo-
gyproducersandinternationalcardnetworksthatobviously
try to spread innovation as fast as possible across banks, a
certain caution is understandable. Going forward, banks
shouldnotonlylimittheirinvestmentstohardwareandtech-
nologicalsupport,theyshouldalsotryandinfluencecustom-
ers’behaviorthroughpricingandeducation.
140 - The Journal of financial transformation
Banks’ strategies for payment services: which role for debit cards?
greater debit card usage through ATMs. In this case, one
major issue is represented by the fact that while activity-
based costing techniques may produce an estimate of the
costofalltypesoftransactionsforabankdependingonthe
channel the customer uses, understanding clearly which
partsofthosecostscanbeactuallyreducedoreliminatedby
migratingtransactionstowardsATMsorotherchannelsisnot
simple.Majorsavingscouldderive intheoryfromreduction
in staff costs, especially for cashiers. Yet, while it may be
simpletouseself-servicechannelstoreducethenumberof
cashiers in each branch to one only, dedicated to complex
transactionsortoresistantcustomers,pursuingfurthercost
savingsbyeliminatingthecashiercompletely isnotequally
easy. The risk is, therefore, that cost savings may remain
largelytheoretical,duetothecleardiscontinuityofthecost
function for each branch. While the possibility that some
banksmaystillhaveanincentivetopromoteATMusagecan-
not obviously be ruled out5, potential advantages may be
higherespecially for thosebanks thathadnotrestructured
theirbranchesyet,andmaintainbrancheswithahigherthan
averagesize.
CustomereducationeffortsdevotedtoincreasinglargerATM
usemaybeparticularlydifficulttojustify,especiallyconsid-
eringthatsimilareffortsdevotedtoincreasecards’usageat
point-of-salesorincreaseInternetbankingmaybemorepro-
ductive.WhileagreaterdevelopmentandusageofPOSter-
minalsmightreducetheneedforcashforsmalltransactions
andthereforemakecashwithdrawalsmoreinfrequent,which
might increase the attraction of investments aimed at
increasingPOSusage,otherchannels,suchastelephoneor
PC/Internet banking, allow customers to get information
abouttheircurrentaccountaswellasundertakeotherpay-
menttransactions,suchasbanktransferorders.Whencom-
paredtoanATM,thesechannelsalsoofferthebankabetter
opportunity to sell other products when the customer con-
tacts the bank for a payment transaction. As a result, it is
likely to think that customer education efforts might be
devoted to supporting the development and usage of tele-
phoneorPC/InternetbankingratherthantheusualATM.
Doubtsconcerningthereturnoninvestmentfromdeveloping
ATMsmaynotbelimitedtoonlybasicfinancialservices,they
couldalsobeextendedtofunctionsthatmoresophisticated
ATMsmayperformandthedeliveryofnon-financialservices.
Infact,extendedfunctionalitydoesnotimplyextrarevenues
but clearlyextra fixed costsdue to theupgradeofexisting
terminals,whichmaybenon-trivialespeciallyforlargerATM
networks.Inpractice,itisrealistictoassumethatfunctional-
ityextensionsmayoccuronlyinthosephasesthatabankis
forcedtoinvestinsubstitutingolder-generationATMsdueto
theclearobsolescenceofthenetwork.
Theneedtoundertakemaintenanceandupgradingofexisting
networkisjustanexampleofthekindsofinvestmentthata
bankmayfacesimply inordertomaintainthesameservice
quality as its competitors, and that may certainly influence
their willingness to invest further in more ambitious card
usage development programs. From this viewpoint even a
relevant and important technological change, such as the
migration of debit cards from magnetic stripe to chip card
technology,whileopeningupnewopportunitiesforsaferand
greatercardusage,willnecessitatesignificantinvestmentsin
upgradingmerchants’terminals.Again,immediatecostsmay
be clearer and more evident to both banks and merchants
thanfuturereturns,orthepossibilityofbecominglatemovers
insuchafield.
A second source of resistance to investment on debit card
maybeassociatedwithrecentexperiencesofinvestmentsin
Internet banking. In many countries there had been a clear
overstatement of the growth potential of Internet and PC
bankingchannels.Manybankshad,therefore,investedsignifi-
cantamountsofmoney(perhapspartiallyforasinceretrust
on Internet potentiality, and partially simply for an uncon-
scious ‘me-too’ strategy) that did not generate adequate
returns.Thisfacthashadatleasttwoconsequencesthatmay
berelevantforouranalysis.
ThefirstconsequenceisthatifthereisovercapacitywithPC
andInternetbanking,itlooksnaturaltoconcentrateeffortson
141
Future
delivering migrant workers’ remittances
Roger BallardDirector, Center for Applied South Asian Studies,
university of Manchester
143
Abstract
Asglobalizationhasledtoeverhigherlevelsoflabormobility,
sothevolumeoffundsremittedtotheirfamiliesbyworkers
employed in countries far distant from their homes has
increased by leaps and bounds. The total volume of such
transfers currently amounts to over U.S.$100 billion per
annum, the greater part of which flows from economically
advancedregionsintheWestandNorthtodevelopingcoun-
tries in the East and South. Delivering those funds swiftly,
reliably,andcheaplytorelativelyremotedestinationsopens
upnewopportunities for the financialservices industry,but
alsorepresentsamajorlogisticalchallenge.
Although many banks and money transfer agencies have
recently begun to consider how they can make the most of
theseopportunities, those thatseek toenter this fieldsoon
findthattheyareupagainstveryeffectivecompetition:the
InformalValueTransferSystemswhichmanymigrantgroups
havethemselvesdevelopedtomeetthischallenge.Inapost
9/11context, therehasbeenmuchfevereddiscussionabout
thethreatwhichsuch‘undergroundbanking’networksalleg-
edlypresenttothestabilityoftheglobalorder.Inaneffortto
replace ill-informed speculation with empirically grounded
detail, this paper demonstrates the extent to which such
informal networks have developed in such a way that they
nowprovideahighlyefficientresponsetothelogisticalchal-
lenge of delivering migrant remittances. In doing so it also
setsthesceneforamore informeddebateabouthowIVTS
networksmightbestberegulated.
1 Ratha,D.“Workers’Remittances:AnImportantandStableSourceofExternal
DevelopmentFinance”.GlobalDevelopmentFinanceReport.WorldBank,
WashingtonD.C.(2003)
2 HouseofCommonsInternationalDevelopmentCommittee.“Migrationand
Development:Howtomakemigrationworkforpovertyreduction”HC79-1.The
StationaryOffice,London(2004)
3 AnoverviewofthegrowthandqualitativecharacteristicsofBritain’sSouthAsian
populationcanbefoundinBallard,R(Ed).“DeshPardesh:TheSouthAsian
PresenceinBritain.”C.HurstandCo.,London(1994).
4 Piore,M.J.“BirdsofPassage:MigrantLabourandIndustrialSocieties.”Cambridge
UniversityPress,Cambridge(1979).
delivering migrant workers’ remittances
population of migrant workers’ consequent need to find a
safe,speedy,andreliablemeansoftransferringtheirsavings
backtotheirkinsfolk,especiallywhen,aswasveryoftenthe
case,theylivedinrelativelyremoteruralareas.Hencejustas
themigrantsorganizedtheirownmeansofentryintodestina-
tionlabormarkets,whichinmanycasesinvolveriskingtheir
lives, theyalsodevised theirownmeansof sendingsavings
backhome.Whilstthephysicaltransferofcurrencynoteswas
themostobviouswayofdoingso,long-distancemigrants,and
especiallythosewhoseresidencerightswereuncertain,were
unabletomakehomevisitswithanyfrequency.Butasthey
soondiscovered,theformallyconstitutedfinancialsectorwas
ill-equipped to meet their needs. Over and above delivery
problems, the commissions charged by banks, let alone by
specialist money-transmission agencies, such as Western
Union, consumed an alarmingly significant portion of their
hard-earned savings. Hence wherever groups of labor-
migrantsestablishedethniccoloniesofanysize they invari-
ablywentontodeveloptheirownself-constructedstrategies
ofinformalvaluetransmission.
Astheyearshavepassed,mostoftheseinformalalternatives
havebecomesteadilymoresophisticated,aidedbyadvance-
mentsincommunicationtechnology,particularlyintermsof
the development of fax and then the Internet, which have
madeitpossibletoorganizelarger-scalevaluetransferswith
speed, accuracy, and with high levels of reliability. Hence
whilsttheseinformaltransfersystemswentlargelyunnoticed
duringtheirinitialyearsofdevelopment,withtheturnofthe
centurytheysuddenlybecamethefocusofmuchhigherlev-
elsofinstitutionalattention.Thereweretworeasonsforthis
seachange. Inthefirstplaceoncemillionsandthentensof
millions of dollars began to be transmitted through these
InformalValueTransferSystems(IVTS),theybegantobesuf-
ficientlylargeastomakeblipsoninstitutionalradarscreens.
Henceanumberofmajorbanks,ledbythosebasedintheU.S.
with an outreach into Latin American markets, began to
explorewhether itmadecommercial sense tomakeamore
activeresponsetothepotentially-profitablebusinessoffacili-
tating remittance transfers. Secondly, and ultimately even
more importantly, questions began to be asked about the
extenttowhichtheseIVTSnetworkswerebeingusedtopro-
videacoverforlaunderingtheprofitsofdrugsmuggling.And
although initial reports5 were rather skeptical about the
extenttowhichIVTSwasactuallybeingusedasavehiclefor
criminal malfeasance, rather than a convenient means of
facilitating wholly legitimate remittance transfer, the whole
debatewastransformedintheaftermathoftheeventsof9/11.
Even though the greater part of the 9/11 operation was
financedbywiretransfers intopersonalaccountsopenedat
theSuntrustBankinVenice,Florida6,amassofluridly-written
articlessoonappearedinthepresssuggestingthatHawala/
IVTS networks were in fact a wholly unregulated form of
‘undergroundbanking’whichprovideddrugs smugglersand
terrorists a vehicle for financing their evil deeds. Hence,
despitetheabsenceofanysubstantialbodyofevidencesup-
portingsuchaccusations,governmentsthroughouttheworld
have found themselves under ever increasing pressure, for
the most part articulated by the U.S. Treasury, to introduce
regulatorymeasureswhichcouldineffectputallsuchinfor-
maloperationsoutofbusiness.
However,aseveryonewithinthefinancialservicesindustryis
now very well aware, draconian initiatives whose central
objectivesweretocounterbothmoneylaunderingandterror-
istfinancingwerebynomeanslimitedtotheinformalsector.
Suddenlyvirtuallyeveryagencyengagedinanykindoffinan-
cialtransactionsonbehalfofpersonalcustomersfoundthem-
selves required to introduceelaborateKnowYourCustomer
procedures,andalsounderaduty,backedupbyseverecrimi-
nalsanctions,tosubmit‘suspicioustransactionreports’,espe-
ciallyinthecaseofcashtransactionsinexcessofU.S.$10,000.
Whetherthisnewregulatoryenvironmentishavinganyeffect
ontheproblemsitisdesignedtoconfrontremainstobeseen.
What is undoubtedly the case, however, is that as a conse-
quenceoftheseinitiativesitisnotjustIVTSnetworkswhich
havefoundthemselvesunderpressure.Financialinstitutions
of all kinds now find themselves faced with the necessarily
expensivetaskofgatheringandrecordingagreatdealmore
personaldataabouttheirclientsandtheirtransactionsthan
144
delivering migrant workers’ remittances
1455 Passas,N.,“InformalValueTransferSystemsandCriminalOrganizations;astudy
intoso-calledundergroundbankingnetworks.”http://www.minjust.nl:8080/b_
organ/wodc/publications/ivts.pdf(1999).
6 “The9/11CommissionReport.”GovernmentPrintingOffice,WashingtonD.C.
The growth of migration and remittances in the contemporary worldInthecontextofanevermoreglobalizedlabormarket,many
millionsofpeoplearenowlivingandworkinginlocationsfar
distantfromtheircountriesoforigin,andtowhichtheyregu-
larly remit a substantial proportion of their earnings. The
financialflowsgeneratedbymigrantremittancesinthissense
are by now very substantial. Although accurate figures are
extremelyhardtocomeby,itisnotunreasonabletosuggest
that the current flow of transnational value-transfers cur-
rently generated by migrant workers amounts to at least
U.S.$100billionperannum,andperhapsagooddealmore.
Neverthelessmigrantworkersarefarfrombeingahomoge-
neous socio-economic category. Although the professionally
qualifiedemployeesofmultinationalcompaniesnowtendto
display high levels of spatial mobility during the course of
theircareers,suchhigh-fliersonlymakeupaverysmallpro-
portion of the global stock of migrant workers. Instead the
vastmajorityworkatfarlowerlevelsintheoccupationalhier-
archy.Butalthough theirwagesareonlyasmall fractionof
thoseenjoyedbythehighfliers,mostdisplayamuchhigher
propensity to save, so much so that they frequently send a
substantial proportion of their relatively meager incomes
backtotheirkinsfolkinAsia,Africa,andLatinAmerica.The
size of the resultant transactions, examined one by one, is
verysmall.Thevastmajorityofmigrantsrarelyremitmuch
morethanafewhundreddollarsamonth,merepennypack-
etsinbankingterms.Howeveritisthevolumeofsuchtrans-
actions which gives them their current significance, no less
locally than globally. In many countries of the developing
worldmigrantremittancesnowformthelargestsinglesource
of foreign exchange, comfortably exceeding the sum of all
formsofdevelopmentassistanceandFDI.1
Notonlyhasthescaleoftheseremittanceflowsgrownvery
rapidlyinrecentyears,butso,too,hasthelogisticalchallenge
ofdeliveringthem,notleastbecausesomanyoftheirrecipi-
ents live in remote rural areas, far beyond the reach of the
formalbankingsystem.Howeveragrowingnumberofstake-
holders—stretchingfrommigrantsthemselvestotheirfamilies
andcountriesoforigintotheInternationalDevelopmentCom-
munity—haveaninterestinensuringthatmigrantremittances
areasswift,reliable,andaboveallcheapaspossible.2Itfol-
lows, therefore, that the recent rapid growth in South-North
labor migration, and the concomitant growth of remittance
transfersinthereversedirections,presentsbothamajornew
challengeandanequallysubstantialsetofnovelcommercial
opportunities to the financial services industry. This paper
explores the ways in which those opportunities have so far
beenmet,identifiesthekindsofinstitutionalinitiativeswhich
haveemergedtomeetthem,andonthatbasisseekstolook
forwardtothelikelycourseoffuturedevelopments.
Althoughmigrantshavealwaysplayedamajorpartinprovid-
ing the labor power needed to fuel urban and industrial
growth,anddespitethefactthattheycontinuetobeavital
sourceofmenialworkersinmostpost-industrialsocieties,and
most especially those with plummeting birth-rates, their
arrival has rarely been planned or centrally coordinated.
Moreover all efforts to achieve such coordination invariably
fail,foroneveryobviousreason.Migrantworkersarenotonly
invariably self-selecting, they also behave as self-motivated
entrepreneurs whose principal concern is to advance the
interests of themselves and their kinsfolk.3 Migrants have
always acted thus. No less than the millions of European
migrants who crossed the Atlantic during the 19th and the
20th century, their ever more numerous successors from
Asia,NorthAfrica,andLatinAmericaseekingtheirfortunesin
theaffluentcitiesofothercontinentsarepursuingtheirown
agendasontheirownterms.Indoingsotheynotonlyaimed
tomakethemostoftheincome-earningopportunitiesavail-
able at their destination, but were equally committed to
increasingthewealth,andhencethestatus,oftheirfamilies
andtheircommunitiesbackhome.4
Yetalthoughareverseflowofremittancesfollowsthearrival
ofmigrantremittancesalmostassurelyasnightfollowsday,
until very recently the formally constituted financial sector
madenoorderedeffortstorespondtothisrapidlyexpanding
7 Theempiricaldataaroundwhichthissectionofthepaperisconstructedderives
frommorethanthirtyyears’experienceofethnographicresearchonthegrowth
oftheSouthAsianpresenceinBritainanditstransnationalconnections,which
hasinrecentyearsprovidedaplatformforamuchmoredetailedexaminationof
theactivitiesofHawaladarsoperatingintheU.K.andDubai,aswellasinIndiaand
Pakistan.Between2000and2002IreceivedagrantfromtheE.S.R.C.toconduct
researchonKinship,Entrepreneurship,andtheTransnationalCirculationof
Assets.Awealthofmoredetailedmaterialontheseissuescanbefoundathttp://
www.art.man.ac.uk/CASAS/pages/papers.htm
delivering migrant workers’ remittances
U.S.$1.8billion)peryearbacktoPakistan.7Apartfromabrief
blip when Customs and Excise arrested a series of major
Hawaladars and charged them with money-laundering, the
greaterpartofthesefundsweretransferredbacktoPakistan
through the informally grounded Hawala system, often
throughdealsfacilitatedinDubai.HoweverPakistanisarenot
alone in using this system. To my knowledge similar Dubai-
centered transfer networks have also been established by
immigrantsfromBangladesh,Pakistan,Afghanistan,Iran,and
Somalia. Such networks also facilitate transfers from immi-
grants who have established themselves across the length
andbreadthoftheE.U.
Thesenetworksdidnotspringintoexistenceoutoftheblue.
Whilstthegrowthofmigrantremittancesmayhavedramati-
cally boosted the scale and scope of contemporary Hawala
networks,therootsoftheseoperationscanbetracedbackto
theancientsystemofcommercialbanking,whichgrewupto
servetheneedsoflong-distancetradersintheIndianOcean
region. IntheiroriginalformatHawalanetworksemergedto
oil the wheels of commercial activity, meeting the needs of
long-distance traders who wanted to transport the bullion
theyneededtofinancetheiractivities.Adepositmadewitha
Hawaladarinonemarketplace(theGujaratiportofSurat,for
example)couldbepickedupasacreditfromthatHawaladar’s
correspondingpartnerinBasra,Mogadishu,orMalacca.
Asaresultofcompletingsuchtransactionsontheircustom-
ers’behalf,correspondingHawaladarswereconstantlyshift-
ing debits and credits between one another. Just as in any
other banking system, Hawaladars were prepared to take
these positions because those within any given network
trustedtheirpartnerstohonoreachother’sinstructions,and
abovealltomakeupanynetdeficienciesasandwhenaset-
tlementwaseventuallyimplemented.Althoughsystemsecu-
ritywasascrucialafeatureoftheseoperationsasitisinany
otherbankingsystem, its foundationsweregrounded in the
cultural and religious context of the times. Medieval
Hawaladars largely eschewed the elaborate clerical and
bureaucratic procedures, such as regular inspection of par-
ticipants’ records by accountants and regulators, around
whichcontemporaryWestern-stylebankingsystemsarerou-
tinely constructed. Indeed the only external authority to
whomHawaladars(thevastmajorityofwhomwereMuslims)
wereresponsiblewasAllahhimself.
But,althoughmostHawaladarstook,andstilltake,thetreatof
Divinesanctionsseriously,nonearesoidealisticastorelyon
thatas theprincipalsourceofsystemsecurity. Insteadthey
reliedonrelationshipsofabsolutetrust.Notonlydidthesys-
tem rely on customers having absolute confidence in their
Hawaladars’reliability,theHawaladarsthemselvesneededto
haveasimilarlycomprehensiveleveloftrustineachother’s
honesty.Thiswasnecessarysincedueto thedistancescov-
eredtherewereimbalancesbetweentheparticipantsforlong
periodsatatime.
Becauseoftheneedforabsolutetrust,itishardlysurprising
to find that each network of corresponding Hawaladars,
together with their customer-base, was normally language,
religion,andhencecommunity-specific.Fromthisperspective
HawalanetworksarebestunderstoodasanIslamicversionof
a much wider range of pre-modern forms of long-distance
value transmission and settlement, to which parallel Hindu
andChineseformsofIVTSalsoemergedduringthemediaeval
period,andlikewiseremaininoperationtothisday.Moreover
itisquiteclearthatwhilsteachsuchsystemhasitsownspe-
cific set of cultural and religious roots, all are constructed
around translocal networks of absolute interpersonal trust.
These not only provide a secure channel of communication
betweenspatiallyseparatedfinancialoperators,butarealso
thefoundationsofawebofbindingreciprocitieswhichpro-
vides,ineachcase,abedrockofsystemsecurity.
Whilst religious and sectarian loyalties provided the basic
foundationsofsuchnetworks, thesewere,andstillare,rou-
tinelyreinforcedbytiesofkinshipandmarriagebetweenthe
participants, so generating an even tighter web of mutual
reciprocities.Henceitisthroughtheoperationofsuchinfor-
mally constituted networks, rather than through the imple-
146
delivering migrant workers’ remittances
they had hitherto collected, and even then can often find
themselvesinanuneasypositionforfearthattheymightfind
themselveschargedwithcolludingincriminalactivity.
A new opportunity for the financial services industry?Yetdespitethecostlydownsideofthesenew,albeitstillmuch
disputed, regulatory regimes, these post-9/11 developments
may,at leastonthefaceof it,haveopenedupamajornew
opportunityforthefinancialservices industry.Astable,and
indeedasteadilyexpandingflowofvaluetransfertothetune
ofU.S.$100billionperannumiscertainlynotanopportunity
tobesniffedat,mostespeciallywhenregulatoryauthorities
aroundtheglobeareactivelyencouragingtheformalbanking
sector to become much more heavily involved in providing
services in this sphere, thereby providing migrant workers
withanalternativetowhattheburgeoningAML/CFTindustry
regardsasdeeplysuspectIVTSandHawalanetworks.
Yet despite the obvious opportunities that these develop-
ments have thrown up, those players who have sought to
enter this sector of the global foreign exchange market
appear to be finding the going extremely tough. Devising a
commerciallyviableresponsetothespecificcharacterofcus-
tomerdemandsinthissphereisprovingtobefarfromeasy,
not least because their competitors in the ‘informal’ sector
stillappeartooccupyapositionofclearcompetitiveadvan-
tage,despite thehigh levelsofofficialharassment towhich
theyhaverecentlyfoundthemselvessubjected.
Sojustwhatarethefinancialandlogisticalrequirementsofa
successful remittance transfer operation? Overall volume is
notaproblem.Whatdoescausesevereproblemsisthelogis-
tics of such operations. Given that individual transfers are
mostly in penny packets, most transfers require funds to be
converted into relatively obscure currencies, most senders
prefertomaketheirdepositsincash,andrecipientsfrequently
liveinruralareas,andhencewellbeyondthebankingfrontier.
Inviewofthesechallengesitishardlysurprisingthatspecial-
ist cash delivery operations based in the formal sector, of
which Western Union is currently the most salient example,
regularly charge a commission of around 15% for their ser-
vices,andeventhentheirdelivery-coverageislargelyrestrict-
edtomajorurbancenters,especiallyinthedevelopingworld.
Fromtheperspectiveofill-paidmigrantworkersacutof15%
ontheirhard-earnedwagesappearstobequiteoutrageous,
especiallysincethemarginchargedbyoperatorsintheinfor-
malsectorisdramaticallysmaller,often2%orless.Why,then,
doesWesternUnionfinditnecessarytochargesomuch?And
how,bycontrast,dooperatorsintheinformalsectormanage
to offer a service which is just as reliable and with a much
greaterspatialreachwhilstchargingsomuchless?
Theanswer to the firstquestion isobviousenough.Serving
the financial needs of millions of migrant remitters drawn
fromdevelopingcountriesisanaccountant’snightmare.Given
thatthepacket-sizeofeachtransactionissmallandthedeliv-
ery address is so often as remote as it is obscure, not only
must elaborate and expensive arrangements to consolidate
andthentodeconsolidatethesesmallpackagesateachend
ofthetransmissionchainbedeveloped,butaprocessofcur-
rencyexchange,onawholesalebasisofcourse,mustalsobe
implementedsomewherealongtheway.Becauseofthelarge
number of the administrative staff required to implement
theseprocesseswhenconventionalbureaucraticprocedures
areemployed,costsarenecessarilyhigh.Nomatterhowhard
theytrytocutdownonadministrativecosts,WesternUnion
anditsmanyemergingrivalswithintheformalsectorseelittle
prospectofreducingtheircommissionchargesbymuchfrom
theirpresentlevels.Nowondertheircompetitorsintheinfor-
malsectorarecurrentlyhavingafieldday.How,though,are
theymanagingtopullitoff?
The roots of HawalaIntheU.K.thePakistanicommunity,whichiscurrentlyaround
threequartersofamillionstrong,isthemostactivesources
of migrant remittances, and its members are collectively
responsible for sending anywhere between £500 million
(approximatelyU.S.$900million)and£1billion(approximately
147
delivering migrant workers’ remittances
ofcurrentexchangeratestoprospectivesenders,collectionof
datafromsendersabouthowmuchistobedeliveredwhere
and to whom, and the transmission of delivery data to the
remotedestination.
The second is value transmission and settlement, which
means that they need to organize availability provision of
creditatthepointofdeliveryagainstaccumulateddebitsat
the point of deposit, so enabling the organization of subse-
quentprocessesofsettlement.
Thethirdelementiscollectionanddeliveryofcurrencynotes,
whichinvolvescollectionandconsolidationofsenders’depos-
itsandtheonwardtransmissionofthesefundstosettlement
partners, and the deconsolidation of credits received from
settlementpartnersandtheirdistributiontoassignedrecipi-
entsatavarietyofoverseasdestinations.
Since all remittance agencies, be they formally constituted
banksorHawaladarsoperatingintheinformalsector,facethe
same set of technical and logistical challenges, it is worth
exploringwhichofthetwoisinapositiontoimplementthis
complexsetof taskswith thehighest levelofeffectiveness,
efficiency,andreliability.
A concrete example: the transfer of remittances from the u.K. to Pakistan’s mirpur district Morethanathirdofamillionpeoplewhoseancestralorigins
lie inMirpurDistrictare resident in the in theU.K.,mostof
whomkeepinclosetouchwiththeirkinsfolkbackhome.Not
onlyarevisitsbackandforthextremelyfrequent(PIAoper-
atesnolessthantenflightsintoManchestereveryweek),but
many of the pioneer settlers who arrived in the U.K. forty
yearsagohavenowretired,andarenowtakingtheopportu-
nity touse their accumulated savings tobuild splendidnew
houses for themselves back in Mirpur.8 As a result, remit-
tances from U.K. to Mirpur are currently running at some-
whereintheregionof£250million(approximatelyU.S.$450
million)perannum,thegreaterpartofwhichpassesthrough
Hawala networks. Delivery is routinely achieved within 48
hours,withnosignificantorganizationalfussand100%reli-
ability.Fromthecustomer’sperspectivesendingmoneyback
toMirpurcouldhardlybemorestraightforward.Alltheyhave
todo isapproachtheir localPakistanitravelagent(thevast
majorityofwhomoffersuchservices,eitherintheirownright,
oras theagentofa largerHawalaoperatorbased ina city
which supports a large local Pakistani population), enquire
aboutandagreeuponarateofexchange,provetheiridentity
(arequirementoftherecentlyintroducedanti-moneylaunder-
ingregulations),maketheagreedpayment,andprovidethe
recipient’snameandaddress inMirpur.Within48hoursthe
sumagreeduponwillbereadyforcollectioninMirpur.
Sohowisitallachieved?Asevertheback-officemechanisms
which support these apparently straightforward front-office
resultsareextremelycomplex,somuchsothattheyarebest
consideredinaseriesofstages,allofwhichhavetobefitted
smoothly together for the whole operation to produce the
desiredresult.
The collection of sterling in u.K. and the delivery of rupees in mirpur In front-office terms, Hawaladars engaged in collecting and
dispatchingremittancetransfersnecessarilyworkinclosecol-
laboration with a corresponding partner operating at the
destination(s) to which those remittances are dispatched.
Moreover ifweleavetheissueofsettlementtoonesidefor
themoment,implementingthecomponentofthedealwhich
matterstothecustomer,namelythedeliveryofrupeestothe
recipient,issimplydependentontheswiftandaccuratetrans-
missionof theappropriatedelivery instructions.Howeverto
sendseparatemessagesforeverysingletransactionwouldbe
highlyinefficient,consolidationistheorderoftheday.Hence
each consolidating Hawaladar (and for clarity’s sake let us
identifyhimasHaoperatinginBirmingham9)willmakeupa
list, setting out all daily transactions with over-the-counter
customersandthosepassedontohimbyanetworkofagents
and sub-agents operating in smaller Pakistani communities
elsewhereintheU.K.Thenitisasimpleenoughtasktofaxthe
spreadsheet to his corresponding partner Hb, operating in
148 - The Journal of financial transformation
delivering migrant workers’ remittances
mentationof formalbureaucraticproceduresofpaper trails
andauditinspections,thatIVTSnetworkshavecharacteristi-
callyachievedaconditionofself-regulation.Whilstrelianceon
self-regulationinthissensemayseemasold-fashionedasitis
insecure,itisworthrememberingthatsolongasthenetworks
withinwhichthesetransactionsareimplementedhaveanall
encompassing impact on their members’ lives, sanctions
against malfeasance, no matter how informal their founda-
tions, can be as far-reaching as they are severe. Breach of
trust characteristically leads to swift and comprehensive
socialex-communicationnotjustoftheoffender,butalsoof
hisentirefamily;andbecausethesenetworksarenowbecom-
ing ever more transnational in character, flight offers fewer
andfeweropportunitiesforescape.
The gradual eclipse and subsequent revival of HawalaFinancialoperationsonlysurviveiftheycansustainaposition
ofcompetitiveadvantage,andIVTSsystemsarenoexception.
WhenEuropeanadventurersinitiallybrokeintoIndianOcean
tradingsystemsinthe16thcenturytheysoonfoundthatthey
hadlittlealternativebuttomakeextensiveuseoflocallycon-
stitutedfinancialservices,andforstraightforwardcommercial
reasonstheycontinuedtodosountilthebeginningofthe19th
Century. But as Imperial domination became steadily more
comprehensive,Europeanbanksgainedadominantposition
in major trading centers all around the Indian Ocean. As a
result more indigenous providers of financial services were
drivensteadilyoutwardstowardsthesocial,geographical,and
economicperipheryofthesystem.
However, in the post-colonial world four key developments
havefacilitatedtheresurgenceofIVTSoperationsingeneral,
andofHawalainparticular.Firstly,theimpositionofover-tight
exchangecontrols inmanypartsofthe IndianOceanregion
has resulted in the emergence of a vibrant black market in
foreignexchange.Secondly,asthenumberoflabor-migrants
fromallovertheregiontotheGulfandEuro-Americagrewso
did the amount of migrant remittances. Thirdly, the rapid
growthofmanufacturingactivityinEastandSouthEastAsia
hasleadtoanupsurgeinintra-regionaltradeinmanufactured
goods.Finally,radicalimprovementsincommunicationstech-
nology — including fax, internet, cell- and satellite phones —
have made such transfers more efficient. Taken together,
these developments rapidly gave Hawala operations a new
leaseoflife.
How do contemporary iVTs systems actually work?Although Hawala networks and other similarly structured
IVTS operations are often described as providing under-
groundbankingservicestotheirclients,itisworthremember-
ing that Hawaladars do not provide retail banking facilities,
such as current accounts, taking deposits, or making loans.
InsteadIVTSnetworksarebestunderstoodasspecialistforex
agencies whose sole purpose is to facilitate value transfers
overlongdistancesandbetweendifferentcurrencyregimes,
and in so doing specialize in the delivery of relatively small
sumstorecipientsbasedinremotedestinationsinthedevel-
opingworld.
Fulfillingthatspecialistroleisfarfromstraightforward.Even
thoughthegrossannualflowofcredits intoanygivenlabor
exportingcountrymaywellamounttoseveralbillionsofdol-
larsperannum,closerinspectionsoonrevealsthatorganizing
theswift,reliable,andefficientdeliveryofinnumerablesmall
packetsofvalueonaglobal scale isamajor logistical chal-
lenge.Withthatinminditisworthrunningthroughjustwhat
kindofactivitiesthetasknecessarilyentails.
It goes without saying that in meeting this challenge
Hawaladarsrarelybecomeinvolvedinthephysicaltransferof
currencynotesacrossinternationalborders.Insteadtheyuse
familiarbankingprocessesofconsolidation,deconsolidation,
and settlement whenever and wherever they possibly can.
Hence Hawaladars’ collection, transmission, and delivery
operationshavethreecoreelements,allofwhichareclosely
inter-connected.
Thefirstisinformationprocessing,whichdealswithprovision
1498 AdetailedaccountofthehistoryofmassmigrationfromMirpurDistrict,aswellas
oftheimpactoftheinflowofremittancesonthelocaleconomycanbefoundin
Ballard,R.“Acaseofcapital-richunder-development:Theparadoxicalconsequenc-
esofsuccessfultransnationalentrepreneurshipfromMirpur”inGardnerand
Osella(eds.)Migration,modernityandsocialtransformationinSouthAsia,New
Delhi:Sage,2004.
9 IhaveborrowedthenotationfortheidentificationofHawaladarsasHa,Hb,etc.
fromthemodelsetoutinElQorchi,MaimboandWilson“InformalFundsTransfer
Systems:andanalysisoftheinformalHawalaSystem”WashingtonDC:IMF/World
Bank,2003.Howeverasmysubsequentanalysisshows,Hawaladealsveryrarely
taketheformofthesimplebilateralexchangeswhichtheysetforthintheir
model.
10 Ballard,R.‘HawalaTransformed:Remittance-drivenTransnationalNetworksinthe
post-Imperialeconomicorder’inMaimboandRathaeds.Remittances:
DevelopmentImpactandFutureProspects.WorldBankPublications,Washington
D.C.(2004)
delivering migrant workers’ remittances
Inthesecircumstancestheoutflowofmigrantworkerstothe
Gulf, the U.K, and the U.S, together with migrant workers’
constantsearchforcheaperandmoreeffectivemeansofget-
tingtheirremittancesbackhome,hasgivenapowerfulboost
toKarachi’sinformalmoneymarket.
AscomparedwithHawaladarsserving theneedsofmigrant
workers,theircounterpartsinKarachioperateinaverydiffer-
entkindoffinancialcontext.Notonlyarethemajorityoftheir
customers drawn from the city’s business and professional
elite,butsuchordersforU.S.$areinvariablyonasubstantial
scale.HenceasingleorderforU.S.$inKarachimaywellgen-
erateasufficientquantumofrupeestomeetaweek’sworth
of daily out-payments in penny packages handles by Hb in
Mirpur.Finalsettlementcanonlybeachievedwhenthehard-
currencycreditsheldbyHainBirminghamhavebeentrans-
ferredtothedestinationsspecifiedbythecustomersofHcin
Karachi.
dubai as a settlement hubMostsuchdealsarecurrentlybrokeredinDubai.WhyDubai?
NotonlyhasDubaitakenadvantageoftheboomintheprice
ofoiltoestablishitselfastheGulf’smostimportantcommer-
cialentrepôt,butasaresultofitscloseproximitytoBombay
andKarachi,thestabilityoftheDihramslinktothedollar,and
itsconsequentconditionofunrestrictedaccesstotheglobal
financialsystem,ithasbecomeSouthAsia’spremieroffshore
banking center. So it is that Dubai’s Exchange houses have
cometoplayakeyroleasfacilitatorsofremittanceandcom-
mercially-driven Hawala settlements not just to serve the
financialneedsoftheverysubstantialmigrant-workerpopula-
tion intheoil-richregionswhichsurround it,butalsoonan
ever more global scale. Hence with their newly established
headquarters in Dubai, Hawala networks, which have their
rootsinmediaevalpractices,haveonceagainbeguntooilthe
wheelsoftradeintheentireIndianOceanregion.10
A worked exampleWithall this inmind,aworkedexample,albeitmuchsimpli-
fied,mayprovideaclearerandmoreconcrete indicationof
justhowthewholesettlementprocessoperates.Letussup-
posethatHainBirminghamhastakenordersforthedelivery
ofRs.10millioninMirpur,forwhichhehasreceived£75,000
fromhisU.K.-basedcustomers.MeanwhileHcinKarachihas
a customer who wished to purchase $100,000 in order to
settlethe invoiceforaconsignmentoftelevisionswhichhe
has imported fromChina,whosemanufacturer isexpecting
paymenttobemadeintohisU.S.$accountinHongKong.Ha
andHcseparatelyapproachaspecialistsettlementbrokerin
Dubai,Hd,whocalculates(forthesakeofargument)thatRs.
10million=U.S.$100,000=£75,000,sogeneratinganideal
opportunity toarrangeaback-to-backswap.HenceHdsets
upaHawalasettlement inwhichHabuysU.S.$ 100,000on
Londonmoneymarketthroughhisbankwhichhepromptly
sends by TT to Hd’s account with Bank of America in New
York; meanwhile Hc takes delivery of Rs. 10 million in cash
from his television-importing customer, which he promptly
dispatchesbyroadtoHbinMirpur,therebyrecompensingHb
for the disbursements made in response to Ha’s previously
faxed instructions; and last but not least Hd transfers
U.S.$100,000byTTfromhisaccountinNewYorktothetele-
visionmanufacturer’saccountinHongKong,thusfullyclos-
ingthecircle.
Howeveritgoeswithoutsayingthatthisisonlyahugelysim-
plifiedexample,andthatintherealdealssuchsettlementsare
agreatdealmorecomplex.Henceintheinstancecited,there
is every prospect that Hc in Karachi would approach Ha in
Birminghamdirectly,andhavingfoundaneatmatchbetween
their immediate financial requirements would do a simple
swapbetweenthemselves,suchthattherewouldbenoneed
to looktoHd,whowould inevitablytakeasmallpercentage
cutonthedealtofacilitatesuchasettlement.
Inpractice,opportunitiestoimplementneatlymanagedswaps
involving such large sums are relatively rare, given that
Hawaladarsoperateinsuchawidevarietyofnationalarenas,
fromwhichtheyseektomakedealsinmanydifferentcurren-
ciesintrancheswhichveryrarelymatchupanythinglikeso
neatlyas theydo in theexamplecited. It follows that since
150 - The Journal of financial transformation
delivering migrant workers’ remittances
Mirpur,whocanpromptlysetaboutorganizingthelocaldeliv-
eryofrupeestorecipientsasinstructed,andwherenecessary
using his own network of agents and sub-agents to make
deliveriestorecipientsresidentinvillagesinthemoreremote
partsoftheDistrict.Pleasenotethattherehasbeennotrans-
fer of value from Ha to Hb. Corresponding Hawaladars are
readyandwillingtotakeonsuchapositionofindebtedness
given the relationship of trust between them, but at some
stagethatconditionmustofnecessitybedischarged.
organizing settlementBecausethemajorityofmigrantworkersaredrawnfromrela-
tively remote rural areas the most distributing Hawaladars
operateinregionswherethereisnosignificantlocaldemand
forforeignexchange.ThatiscertainlythecaseinMirpur,so
Hbrarelyifeverhaslocalcustomersinterestedinexchanging
rupeesforthesterlingcreditswhichheisconstantlyaccumu-
latingwithHainBirmingham.However,inPakistan’scommer-
cial capital, a thousand miles away in Karachi there is an
almost insatiable demand for access to hard currency, for
whichmembersofthelocalbusinesselitearefrequentlypre-
paredtopaypremiumrate.Hencethe informalmoneymar-
kets in Mirpur and Karachi are effectively mirror-images of
oneanother.Thisprovidesanobviousopportunitytoorganize
and implement complementary back-to-back settlements,
withtheaddedriskofhavingtomovethecashbetweenthese
twocities,whichinmostcasesrequirehiringofarmedguards.
Karachi’s Hawala market Likemanyotherdevelopingcountries,Pakistanhaslongsuf-
feredfromaseveredeficitinitsbalanceoftrade,whichisonly
partiallyremediedbyremittancesandotherinvisibleexports.
SinceKarachi isPakistan’scommercialcapitalaswellasthe
country’s principal entrepôt, a major manufacturing sector,
the city has long supported a pent-up demand for foreign
exchangetosettleinvoicesformanufacturedgoodsimported
fromoverseas,topurchaseeducation,medicaltreatment,and
propertyoverseas,toaidthewealthytoexportcapitaltohard-
currency tax-havens beyond the purview of the Pakistani
authorities,andtoreplenishtheStateBank’sforeign-currency
reserves.
151
delivering migrant workers’ remittances
Regulation: is Hawala broke? And does it need fixing?Whilst there can be no doubt whatsoever that Hawala net-
works, as well as their Chinese and Latin American equiva-
lents, provide an excellent deal from the perspective of the
manymillionsofmigrantworkerswhoregularlyutilize their
facilities, the prospect that these informal, and currently
almostcompletelyunregulated,systemsmightalsohavesig-
nificant operational down-sides also needs careful consider-
ation.Itis,therefore,importanttodeterminehowsecuresuch
valuetransmissionsare,asfarasitsretailcustomersarecon-
cerned, and how vulnerable such networks are to criminal
penetration?
Effortstoanswerthesequestionshaverecentlybeguntopre-
cipitateadebateabouthow,onwhatbasis,andtowhatends
this increasingly significant corner of the global foreign
exchangemarketmightbestberegulated.Fourequallypress-
ingquestionshavenowbeguntobeposedwithinthatdebate:
■ TowhatextentdocurrentHawalanetworkshaveanyin-
builtguaranteesofsystemsecurity?
■ Iftheseguaranteesareeitherabsentorinadequate,what
measuresmightrealisticallybeintroducedtoimprove
currentlevelsofsystemsecurity?
■ Isthereanywayinwhichadequateandeffectiveregulato-
rymeasurescanbeintroducedwhilststillretainingthe
strengthsofsuchsystems’informalprocedures?
■ Shouldalleffortsbeconcentratedondrivingallthese
dangerouslyinformalfinancialtransfersintotheproperly
regulatedforexchannelsmaintainedbytheformalbank-
ingsector?
How vulnerable are contemporary Hawala systems to criminal penetration? Yet,evenifweacceptthattheseinformalsystemshavebeen
providing an efficient, effective, and above all a reliable
responsetothelogisticalchallengesthrownupbytheexcep-
tionallyrapidgrowthintheNorthtoSouthremittancedeliv-
ery market in recent years, the priorities of the regulatory
authorities have undergone a sea-change since 9/11. Hence
whilstcustomer-protectionstillremainsasignificantcompo-
nent of the regulatory agenda, measures to curb money-
launderingingeneral,andthefinancingofterroristactivities
inparticular,havesuddenlyleapttotheheadofmanyagen-
cies’ concerns. Given that IVTS networks stand beyond the
reach of any kind external regulation, alarmist accounts of
their vulnerability to criminal penetration are now regularly
articulatedinallmannerofofficialreports,mostparticularly
thoseemanatingfromNorthAmerica.
Yetdespitetheseregularlyarticulatedconcerns,whichhave
inturnledtotheintroductionofaswatheofanti-moneylaun-
deringinitiativeswithwhichtheentirefinancialservicessec-
tor, formal as well as informal, is now required to conform,
muchlessattentionhasyetbeenpaidtodeterminingjusthow
fartheinformalsectorhasactuallybeenusedforsuchnefar-
ious purposes. In a similar vein it is also worth noting that
there have been even fewer efforts to explore whether the
raftofanti-moneylaunderinginitiatives,withwhichallinstitu-
tionsintheformallyconstitutedfinancialservicessectorhave
tocomply,havehadanysignificant impactontheirnominal
targets.If,asIstronglysuspect,theirimpactsofarhasbeen
moresymbolicthanreal,itishightimetoconsiderwhatalter-
native initiatives might be expected to produce the desired
result.
Beforeproceedingfurtheritisalsoworthremindingourselves
that money-laundering is a catch-all term covering a wide
varietyofdifferent formsof financialmalfeasance.Notonly
doestheextentandcharacteroftheir‘criminality’varyenor-
mously, but there are excellent reasons for suggesting that
onlyasmallminorityofthetransactionssolabeledareassoci-
ated either with drug-smuggling or with terrorist finances.
Insteadthevastmajorityaretheoutcomeofstrategieswhich
bothindividualsandcorporationsregularlydeviseasameans
of confounding the efforts of national governments to tax
their income,to imposeexcisedutiesongoodstheywishto
importorexport,and/ortoimposerestrictionsontheirability
to export funds into alternative financial jurisdictions. The
152 - The Journal of financial transformation
delivering migrant workers’ remittances
mix’n’match settlements are extremely complex to set up,
theyregularlyrequirethelubricatingassistanceofbrokersin
Dubaiifsuchexercisesaretobeswiftlyandsmoothlyimple-
mented.Moreoveralltheevidenceoftheresultantsettlement
transactionswhichIhavesofarbeenabletoobtainsuggests
thattheyareconductedonaverysubstantialscale,sincethe
basic unit of account in making such deals appears to be
U.S.$100,000.
How secure is iVTs/Hawala as far as its retail customers are concerned?Whilstbillionsofdollarsareprocessed throughDubai-based
IVTS/Hawala networks every year, it is striking that despite
theabsenceofanykindofcentralregistry,letaloneacentral
regulator,seriouscustomercomplaintsarevirtuallyunknown.
Howcan thisbe?Thebasicanswer isquitestraightforward:
likethepre-colonialstructuresfromwhichtheyevolved,con-
temporary Hawala networks are best understood as distrib-
utedsystemsinwhichsystemsecurityisrootedinthetrans-
nationally extended relationships of absolute trust which
participating Hawaladars routinely maintain between them-
selves.Giventhatallmembersofthenetworkareactivepar-
ticipantsinthewholeenterprise,systemsecurityisnotonlya
matterofcollectiveconcern,butisalsoarticulatedfromthe
bottom up, in sharp contrast to the top-down patterns of
externalscrutinyandregulationwhichcontemporaryWestern-
stylebankingsystemsroutinelydeployforthatpurpose.
It isalsoworthemphasizing thatsuch informalmethodsof
guaranteeingsystemsecurityarefarfrombeinganoutmod-
ed hangover from by-gone age. Quite the contrary, such
practicesappeartobetheprimesourceofthesystem’scom-
petitive advantage, above all because they allow large
swathesofoperationallyredundantclericalandbureaucratic
activity to be stripped out of the system. By doing so,
Hawaladars are able cut down information transmission to
theminimumlevelrequiredtoimplementthetaskinhand,so
enabling their core business of value transmission to be
implementedwiththemaximumlevelofspeed,reliability,and
efficiency. Moreover having adopted such a lean and mean
approachtothedatawhichtheychoosetotransmitbetween
themselves, Hawaladars have typically taken immediate
advantage of developments in communications technology.
Henceinadditiontolandlinesandmobilephones,Hawaladars
havemovedrapidlyonwardsthroughfax,email,networkpor-
talsandsecureVirtualPrivateNetworksasameansofinfor-
mation transmission amongst themselves, whilst all of the
largeroperators,andanincreasingnumberofsmallerones,
have now begun to plug directly into inter-bank electronic
valuetransfersystems,suchasBACSandSWIFT.
Giventhemanifestcommercialefficiencywithwhichcontem-
porary Hawala systems cope with the logistical challenges
thornupbymigrantworkers’financialservicesrequirements,
as well as the ever-greater technical sophistication of the
transferandsettlementprocesseswhichtheyhavedeveloped
in order to meet those requirements, the use of the term
‘informal’asmeansofcharacterizingthesystemasawhole
needs to be approached with considerable care. In the first
place,anysuggestionthatHawala’sinformalcharactermeans
thatitis‘asystemwithoutrecords,’asthosewhosuspectthat
thewholeexerciseismerelyaconvenientcoverforcriminal
activity frequently argue, falls by the wayside. Despite their
commitment to reducing clerical procedures to a minimum,
thereisnowayinwhichHawaladarscoulddealaccuratelyand
efficientlywithtransactionsofthecomplexitytowhichremit-
tance transferprocessesgive risewithoutextensive record-
keeping.Secondly,andconsequently,‘informality’isnottobe
confusedwithbackoftheenvelopeprocedures.Onthecon-
traryHawaladarshavebeenmuchquickertomakeuseofthe
efficiencygainswhichcanbeextractedfromrecentdevelop-
ments in electronic communications than their rivals in the
formalbankingsector.
Thisimmediatelypromptsafurtherquestion.Coulditbethat
the competitive advantage currently enjoyed by contempo-
raryIVTSnetworksissimilartotheadvantagesInternet-based
retail banks have over their branch-based competitors that
arestrugglingwiththecripplingcostsofmaintainingapres-
enceonthehighstreet?
15311 Robinson,J.TheSink:Terror,CrimeandDirtyMoneyintheOffshoreWorld
Constable.London(2003)
12 PublicAffairs(2004)The9/11CommissionReportNewYork:PublicAffairs.
delivering migrant workers’ remittances
serious financial arsonists long since perfected the art of
buildingsmokelessfires.Inthesecircumstancesthereareno
shortcuts. Ifthesecurityservicesreallywanttotrackdown
terrorists,andiflaw-enforcementofficersreallywanttotrack
downdrugsmugglers,neithercrackingdownonHawaladars
norevermoreelaborateKYCrequirementsarelikelytobeof
muchuse.Iftheauthoritiesreallywanttocatchterroristsand
drugsmugglers,ratherthantogenerateheadlineswhichsug-
gesttothepublicatlargethatsomethingisbeingdone,there
appearstobenoalternativetothehardslogofdetectivework
in which suspect transactions, no matter how complex and
obscure,aretrackedrightthroughfromoneendtotheother,
and arrests are made. The current scatter-gun approach,
which appears to be as much directed at the formal as the
informalsector,maywellbeavehicleforbringingsuccessful
prosecutionsagainstthosewhohavefailedtoconformtopost
9/11 regulatory requirements. If the ‘war on terror’ goes no
furtherthanthat,suchsurrogatesuccessesappeartobelittle
morethandiversionaryexercises inpublicrelations. Insuch
circumstancesterroristsanddrugsmugglerswillcontinueto
wend their way through the global financial system with no
greaterdifficultiesthantheyhavesofarenjoyed.
conclusion In my experience the vast majority of Hawaladars have no
greatobjection,atleastinprinciple,tosubjectingthemselves
and theiroperations to regulatory scrutiny, especially if the
centralaimofthoseregulationsistoensurethattheirfacili-
ties are not being surreptitiously utilized by terrorists and
drugsmugglers.Afterall,likeallotheroperatorsinthefinan-
cial services sector they have businesses to run, and client
confidencetomaintain.Blithelyprocessingcriminal transac-
tionswould innowaybeworthwhile in straightcommercial
terms.
However, given that they have businesses to run, and that
positionofcompetitiveadvantagearisespreciselyfromtheir
capacitytoimplementlong-distancevalue-transfersonacom-
prehensively lean-and-meanbasis,noHawaladarwouldever
wishtobesaddledwitharequirementtoimplementelaborate
bureaucratic procedures of questionable utility, most espe-
ciallyifthoseproceduresstoodcomprehensivelyatoddswith
thewayinwhichhisbusinessroutinelyoperated.Bythesame
token it also makes little sense to demand conformity to a
regulatoryregimewhichwasdesignedforuse inabusiness
whichiswhollydifferentincharacter13.Nevertheless,itisto
everyone’s advantage, except for committed criminals, that
HawalaandothersimilarIVTSnetworksshouldbebroughtin
outof thecold.But thatwillonlyoccurwhenmuchgreater
cognizanceistakenofthewayinwhichcontemporaryremit-
tance-driven value-transfer systems actually operate, such
that appropriately-grounded and genuinely reality-checked
regulatoryprocedurescanbeintroduced.
Meanwhileonquiteanotherlevelaltogether,therecanbeno
doubt whatsoever that IVTS networks are highly effective
service-providers inan increasinglysignificantcornerof the
globalfinancialservicessector.Moreoveritshouldbynowbe
quiteclearthatinformalinthiscontextshouldnotbeviewed
as either casual or unsophisticated. IVTS networks are in
essence a highly efficient technical response to some very
substantiallogisticalchallenges.Assuchtheyhaveemerged
asverysignificantcompetitorstomoremainline institutions
whichoperateonamore formalbasis.ButasGerryAdams
said of Irish republicanism, ‘it’s not going to go away, you
know.’JustasJapan,andmorerecentlyChina,havereversed
thetermsoftradebetweenEastandWestthroughtheirinno-
vations in the manufacturing sector, we should also not be
surprised if similar challenges from below also begin to
emergeinthefinancialsector.Thisisnottosuggestthatthere
is any likelihood that Hawaladars will be turning the way in
whichtheentireestablishedfinancialservicessectoroperates
on itshead.But, it is tosuggest that in thespecific fieldof
long-distancecrosscurrencyvaluetransfers,theformalsec-
torhasagreatdealtolearnfromitsmoreinformalcompeti-
tors.
154 - The Journal of financial transformation
delivering migrant workers’ remittances
resultantcontradictionsareof longstanding.Justas states
havealwaysneededtotaxtheirsubjects inordertofinance
their activities, their subjects have done their best to avoid
them.Consequently,ifHawalanetworksalsoprovidesupport
forsuchevasivestrategies,whichtheyalmostcertainlydofor
peopleofthedevelopingworld,weshouldnotbegreatlysur-
prised.Howeversuchstrategiesareinnosenseuniquetothe
informalsector.Onthecontrary,itseemsquiteclearthatall
thebiggestplayers,aswellasthevastbulkofthefundslaun-
dered inthissense,slipwitheasebetweenon-andoffshore
institutionswhicharefirmlylocatedwithintheformallycon-
stitutedfinancialsector.11
Aml/cFTWhat,though,abouttransactionsatthemuchmoreserious
endofthemoney-launderingspectrum,drugsmugglingand
terroristfinancing?Herewemoveintoevenshadierfinancial
arenas. By contrast with the vast sums of money regularly
transferredaroundtheglobetofacilitatetaxevasioninallits
variousforms,thevolumeofcross-currencytransfersgener-
ated by drug-smugglers seems to be relatively small. For
example,althoughAfghanistanmaycurrentlybethesource
of around 80% of the world’s heroin supplies, it is quite
unreasonabletosupposethatanythingmorethanatinypro-
portion of the profits accruing from its sale in Europe and
North America ever come anywhere near the country in
whichthepoppycropisgrown.Drugsmugglersmayindeed
needtolaundertheirill-gottengains,butitmakesnosense
for themtoseek todosoby investing in theeconomiesof
failed and near-failing states. Meanwhile there is a growing
awarenessthatthesumsrequiredtofinanceterroristatroci-
tiesaresosmall thatmanycommentatorshave likenedthe
taskofidentifyingsuchtransferstolookingforaneedleina
haystack. The FBI estimates that the cost of mounting the
September11attackswassomewherebetweenU.S.$175,000
and U.S.$200,000, very small beer in the context of the
globalforexmarket.Moreoverthebulkofthesefundswere
dispatchedtotheU.S.bywiretransferintoanaccountwhich
two of the perpetrators opened at the SunTrust Bank in
Venice,Florida.12
Thefactthatthosefundsweretransferredthroughtheformal
bankingsystemalsoraisesanotherimportantwiderquestion:
towhatextentaretransfersmadethroughinformalsectors,
as is widely assumed, ‘more anonymous’ than those sent
throughmoreestablishedbankingchannels? Infactthere is
goodreasontosupposethat theopposite is true.Bydefini-
tion, Hawaladars normally know their customers on a per-
sonalbasis.Whensuchcustomerstransfersubstantialsums
ofmoney,theHawaladarswillnormallyhaveaprettyshrewd
ideaofthesourcesofthosefunds,andthepurposesforwhich
theyhavebeendispatched.Moreover,ifheknowsthatthere
isaprospectthatthosefundshavebeenacquiredonaseri-
ously illicitbasis thentheHawaladarwhotakesthosefunds
aboardwillbewellawarethatbyimplementingthatdealheis
implicitlyconfirmingthebonafidesofthewholetransaction
as far as all his partners in that Hawala network are con-
cerned, needlessly putting the integrity of the system as a
wholeatrisk.Inotherwords,notonlyareHawaladarslikelyto
be aware of which of their customers might be engaged in
shadydeals,but theyarealsounderasignificantdegreeof
systematicpressuretokeepclearofsuchtransactions.
Bycontrasttherearegoodreasonsforsupposingthatserious
criminalshaveamuchbetteropportunityofpreservingtheir
anonymitybydealingwiththeformalbankingsector.Post9/11
Know-Your-Customer AML procedures with which all major
institutionsinthefinancialservicesindustryarenowrequired
toconformareexpensiveto implement,andcustomersmay
oftenbeannoyedbytherequirementtoproduceavarietyof
documentstoverifytheirpersonalidentity.Howeverthereis
noreasontosupposethatthosedeterminedtoslipbeneath
thenetwouldhaveanydifficultywhatsoeverindoingso.
Money, it is worth remembering, is merely a medium of
exchange.Itisneitherblacknorwhite,andneitherguiltynor
innocent.Iftheauthoritiesarereallyconcernedabouttrack-
ingdownseriouscriminalactivitiesitisbecomingincreasingly
clearthattodososolelyonthebasisofseekingto identify
‘suspicioustransactions’ishighlyunlikelytoprovidepositive
results.Whilstsmokedoesnotnecessarilyconcealafire,most
15513 IntheNetherlandsandGermany,forexample,currentregulationstreatvalue
transmissionagenciesasbanks,andhencerequirethemtomaintaincapital
reservesandtouseauditproceduresofthekindwhichareentirelyappropriatefor
institutionswhichofferacomprehensivebankingservices.Inthefaceofsuch
requirementshawaladarshavenoalternativebuttoconducttheiroperations
‘underground’.
Future
check 21 and the migration to electronic payments
Adam denerPartner, Capco
Abstract
Thisarticleexploresthe increasingchanges inpaymentand
payment flowsdrivenby regulation,customerbehavior,and
technology.TheimplementationofCheck21legislationinthe
fourthquarterof2004will furtheracceleratethemigration
frompapertoelectronicpayments.Thischangeisexpensive
andwillimpactbanks.Bankinginstitutionswillneedtoinvest
inthefront-,middle-,andback-officeinfrastructureswithtotal
industrycoststoexceedU.S.$10billionoverthecourseofthe
decade.Theincreasingmigrationalsoraisesriskstothebanks
as businesses are better able to gain benefit from changes
andinturnwillbebetterabletocollectfunds.Theaccelera-
tion of collection has significant potential negative conse-
quencesonbankrevenuesfromdepositsandpaymentprod-
ucts.
157
check 21 and the migration to electronic payments
permit and/or likely enable stopping the flow of original
checks in thecollectionand/or returnprocess, reducing the
physical processing and shipping of checks, establishing
agreementtocollectorreturncheckselectronically,andcre-
atingnetworkagreementsfromthousandsofbankstoaccept.
The detailed provisions of The Check 21 Act incorporate a
framework that includes the definition of substitute checks,
the establishment of a new negotiable instrument, and an
agreementthatasubstitutecheckisapaperreproductionof
theoriginalcheckandcanbeprocessedassuch.Thepaper
reproductionmust,however,meetindustrystandardsforsub-
stitutechecks,includeanimageofthefrontandbackofthe
originalcheck,andbeMICRencodedandmachinereadable.
Asubstitutecheckisthelegalequivalentoftheoriginalpro-
videdthatitaccuratelyrepresentsalltheinformationonthe
frontandbackoftheoriginalcheck,bearsalegendstatingit
isalegalcopyofyourcheckandthatyoucanuseitthesame
way you would use the original, and that no agreement is
neededtotransferalegallyequivalentsubstitute.
Check21doesnot,however,specificallyprovideforelectronic
exchangebanktobankalthoughimplicit inthe legislation is
theabilityforthistypeofserviceprovision.
incorporating imaging into check processing — A u.s.$10 billion problemToday’s check processing environment involves a complex
network of processes involving significant labor, expensive
equipmentandsystems,transportation,andinter-partyaffili-
ations. A key element of determining the necessary check
processes is the predicated location of presentation of the
checkbyortoabank,whichasdiscussedpreviously,isalegal
negotiabledocument.Check21complicatesthissituationby
expandingthescopeofcurrentandpotentialprocesseswhile
increasingtheneedfortechnologysupportfortheequipment
andsystemsthatsupportthem.
The short-term impact of Check 21 compliance will be
increasedexpensestosupportredefinedprocesses, incorpo-
ration of imaging and digital conversion into the processes,
andincorporationofimagingtechnologies.Theselegacycosts
will increase cost-per-check processing in the short term.
Initialtransportationcostreductionswillnotadequatelyoff-
set the increased costs, while redundancy costs inherent in
today’sprocessingenvironmentswillsignificantlyincrease.
We estimate that the industry’s near term investment costs
willbeapproximatelyU.S.$10billionoverthenext3to5years.
This figure includes new imaging input hardware, storage,
retrieval,andsoftwaresupportinginput,storage,andretriev-
al. In addition, it includes network connectivity supporting
input,storage,retrieval,andpresentationaswellastheredun-
dancycostsofcurrentcheckprocessingenvironments,includ-
inglabor.
158 - The Journal of financial transformation
check 21 and the migration to electronic payments
159
RecentlyapprovedCheck21legislationwillbeimplementedin
October 2004, the objective of which is to reduce systemic
riskassociatedwithphysicalcheckmovementandtoprovide
amechanismtoreducethecostsassociatedwithcheckpay-
ment processing. Check 21 creates a newly acceptable pay-
mentinstrumentandprovidesafoundationfortheimagingof
checksasthebasisforcreatingnewpaymentinstrumentsand
theiracceptancebyotherbanks.WhiletheActdoesnotspe-
cifically require that imagesbepresentedbank tobank, the
legalandoperationalfoundationexistsforthisevolution.
However,closerscrutinyofthelegislationpointtosignificant
business risks from both a cost and revenue perspective.
Theseinclude:
■ industry costs —Check21will,overthenext3to5years,
costtheindustryU.S.$10Billiontomanagebankingindus-
trycomplianceimplementationandredundancycosts
associatedwithreductionsinlegacyinvestmentsincheck
processing.
■ cost savings —Post-implementationwillallowforpro-
cessingcostsavingsand,withtheembraceofdigital
presentation,significanttransportationcostsavings.
■ Float and fee revenue loss —Check21posessignificant
revenueriskbymigrationofcheckprocessingtoACHor
digitalchecksatsignificantlylowerfees,changes,and
reductionsincheckfloat.
■ insufficient funds fee loss —Thelegislationalsohasthe
abilitytocreatefundsverificationserviceswhichcould
reduceinsufficientfundsprocessingandfees(NSF).
To date, most observed industry efforts have been compli-
ance, as opposed to business, focused. Given the scope of
both thecostand revenue impact, Iwould recommend that
bankCheck21programsbeaggressivelymanagedasbusiness
programs. There is significant opportunity, as well as risk,
basedonwhichapproachisultimatelypursued.
what is check 21?‘An Act to facilitate check truncation by authorizing substi-
tutechecks,tofosterinnovationinthecheckcollectionsys-
temwithoutmandatingreceiptofchecksinelectronicform,
and to improve the overall efficiency of the Nation’s pay-
mentssystem,andforotherpurposes.’PublicLaw108–100,
108thCongress.
TheCheckTruncationActwassignedintolawonOctober28,
2003 by President Bush. The law, commonly referred to as
Check21,providesalegalframeworkforbankstoacceptsub-
stitute forms of checks effective October 2004. The likely
initial outcomes of the legislation are the reduction of sys-
temic risk of lost checks due to business continuity failure,
suchas9/11,andcostreductionbyallowingbankstoagreeto
electronic presentation, thereby eliminating the need for
physicalpresentationandtransportationofchecksforsettle-
ment.
Itisthebroaderimplicationsofthelaw,however,thatcreate
evenmoresignificantbenefitsaswellasrisksforbanks.The
legislation will likely serve as an enabler that will form the
basisofcheckdigitizationleadingtodigitalpresentationbank
tobank.
Check21createsalegalandoperationalfoundationthatwill
network and servers
depository bank Paying bank
checkprocessing
consumer
Paper checks
merchant
systems & i/F
clients/customer service
systems & i/F
clients/customer service
checkprocessing
imagearchive
Presentation
Process
Dataflow Imageflow Pointofimpact/enhancement
Figure1:ProcesseswhereCheck21’simpactwillneedtobeaddressed
check 21 and the migration to electronic payments
anddisbursingfloat—theyalso lowertransactionrevenues
andmargins.
Corporationshavebeenwillingtoacceptthepositivebenefits
of converting check-based receipts to ACH transactions,
genericallyreferredtoasCheckConversion.Thisisalsoborne
outbytherapidgrowthofcheckconversiontransactions in
the last24months.Todate,checkconversionhashad little
impact on corporate payments, since it has, by regulation,
beenlimitedtoconsumerinitiatedtransactions.Thissituation
is beginning to change, as the U.S. Treasury has recently
issuedproposedregulationsthatwillallowittoconvertcom-
mercialpaymentstoACHtransactionsaswellifitwishestodo
so.TheimplementationofCheck21truncation,whichhasno
similar limitation, will only likely accelerate the movement
towardselectronicpayments.
The result of these customer and regulatory transitions is
decreasingmarginexacerbationincheckprocessing,ascheck
volumedeclines.Bankattemptstomaintainmarginsbyrais-
ingcheckpricescoulddrivemoretransactionstoelectronic
mediaorcompetitors,compoundingtheproblem.Suchevents
couldfurtherstrainthesignificantinvestmentsincheckinfra-
structuresandeconomics.
Point of presentation image capture (PoPic)Another likelychangerelated toCheck21 is lowerrevenues
predicatedbytheretailneedsofcustomersatpointofpresen-
tation and with bank-to-bank presentment. As noted in the
survey,mostbankimagingeffortshavebeenfocusedoninter-
nalprocessing.Whilecertainindustryeffortshavebeencre-
ated that are focused on inter-bank capabilities, such as
archiving, the advent of bank-to-bank presentment capabili-
tiesandimagecaptureatpointofpresentationwillhavesig-
nificantimpactoncheck-processingeconomics.
Thebulkofretailcheckpresentationoccursatbankbranches,
retailmerchants,andcheck-processingmerchants.Suchpre-
sentationisphysicalacrossmultiplechannels(e.g.ATM,teller,
POS)andrepresentsasignificantopportunitytotransferpro-
cessingcosts to thepresenterby incorporating imaging into
presentation processing. This capability will be of benefit to
bankbranchesandretailerswithsignificantcollectionrequire-
ments. It is likely that some retailers, including banks, may
drivebankproviderstoenablecapabilitiesfortheirbenefit—to
expeditetheircollectionandfloatconcentrationcapabilities—
tothedetrimentoflesssophisticateddisbursersanddisburs-
ingbanks.Theincorporationofimagingtechnologyatpointof
presentationwillbothenablesignificantsavingsandopportu-
nityaswellaschangebehaviorsofend-usercustomers.
In addition, bank-to-bank presentation (B2BP) for collection
will drive furthercostefficiencies.By incorporating imaging
POPIC with electronic presentation processing, settlement
canbeenabledbythepresenterautomaticallywithoutdirect
staffing(ortransportation)otherthansupportforthecusto-
dialfunctionofimagedchecks.
Inadditiontobusinesscontinuityrelatedriskreduction,Check
21 implementation will offer significant long-term financial
incentives for the industry, includingreducedtransportation
costs,processstaffing,andlaborrequirements.
Analogue/paper to digital payments: The risk of lost float and revenue reductionsCheck21regulationsenterthebusinesscycleataprecarious
timeforthebankingindustry.Alreadyundereconomicpres-
sureexacerbatedbytherecentrecessionandcreditcycle,the
160 - The Journal of financial transformation
image capabilities of image enabled banks
statements Rejects Returns Posting
National banks 68% 49% 26% 34%
Regional banks 47% 34% 27% 22%
who would you use as a processor?
3rd Party FRB consortium RPA Another
bank
National banks 27% 4% 0% 4% 12%
Regional banks 45% 35% 32% 25% 11%
check 21 and the migration to electronic payments
The banking industry has the ability to control elements of
this impact through staging, predicated on a redefinition of
processing. However, these impacts could also be driven by
other banks and key customers who could hasten and even
define implementationstagingbypursuing legislativelysup-
portedoperationalbenefits.
Figure1notestheprocesseswhereCheck21’simpactwillneed
to be addressed. These include at point of retail sale (cus-
tomertomerchant),atpointofbranchpresentation(ATMor
teller),checkprocessinginput,checkprocessingsystem,cus-
tomerservicesupport,banktobankpresentation,andimage
archiveandretrieval.
Our2003industrysurveyonpreparednessforcheckprocess-
ing and image automation discovered that only the largest
banks have begun to incorporate imaging technology into
their services. Only 65% of overall respondents indicated
somelevelofimageenablement.Whentherespondentswere
brokendownintonationalandregionalbankswefoundthat
while90%oftheformergroupareimageenabled,only60%
ofthemembersofthelattergroupare.
Thebulkofimagingintegrationisnowfocusedonstatement
processing, with approximately half as much automation in
reject, return, and posting processing. In addition, respon-
dents indicatedabiasagainstsupport fromotherproviders
forimagingenablementthroughincorporationofservicepro-
visions(lessthanhalfofthebanksrespondedinfavor).
cost savings: The payoff from imaging?The manifestations from bank compliance implementation
and the benefits offered by Check 21 have the potential to
significantlyimpactbankcosts,revenues,andevencustomer
behaviors.
AcH adoptionIncommercialpayments,thetransitiontoACHhasaccelerat-
ed with conversion increasing significantly in the past 24
months.TheFederalReservehasnotedACHgrowthrecently
atmorethan15%.WhileACHhastraditionallyofferedlower
directprocessingcosts,commercialpayershavebeenslowto
transfer due to the potentially negative impact on working
capital, in the form of lost float and control over payment
dates. Large, sophisticated companies have historically uti-
lizedinternalandexternalresourcestoanalyzethebenefitsof
usingchecksversusACHpayments,andchangedthosepay-
mentflowstheyfeltbeneficial.
Disbursingcorporationshavethepotentialtolosefloatben-
efitsascollectioncyclescanbereducedthroughutilizationof
Check21-aideddigitizationandelectronicpresentation.Asa
result,companiesutilizingcheckfloatwill likelymodifytheir
processestoneutralizethelostfloatbenefitandcontrol.ACH
mechanisms can enable incorporation of disbursing lags to
attemptcashflowneutrality.
Alternatively, thesecompaniesmayaccept the lost floatas
anaccomplishedrealityandmigratetowards lessexpensive
ACH payments. The impact of this conversion is significant
forbanks.WhileACHservicesofferlowerprocessingcosts—
this transition stranding significant investments in check
processing infrastructuresandsharedbenefitsofcollection
161
check 21 and the migration to electronic payments
traditionalcommercialbusinessisexperiencingclientconver-
sion-basedadoptionofACHwhileconsumerbusinessisunder
margin pressure due to increased competition for account
ownershipamidrisingcostsfornewbranches.Compounding
these challenges, POPIC implementation and bank-to-bank
presentation capabilities have the potential to significantly
reducebankrevenuesviareductionsinfloatrelatedtocheck
collectionandpotentiallyalteringprocessesrelatedtoinsuf-
ficientfunds(NSF)andtransactionfees.
Float revenue reductionDisbursersandbanksbenefitfromcheckfloatinthreedistinct
cycles, mail float, the cycle where the check is in transit to
collector(intransactionswherepresentation isnotatPOS);
Processingfloat,thecyclewherethecheckisbeingprocessed
bythecollectorandbythecollector’sbank;andclearingfloat,
thecyclewherethecheckisbeingmovedfromdepositoryto
payingbankforfinalsettlementandfundsrelease.
Dependent upon the method of presentation, a significant
numberofchecksthatarepresentedviaPOPICincorporating
B2BP would potentially reduce the processing and clearing
cycles.Thiscyclereductionwouldhavesignificant impact in
speedingupavailablecollections,therebyreducingfundsbal-
ancesamongdisbursersandtheirbankingproviders.
Federal Reserve statistics offer significant insight into the
potential impactofCheck21 implementation.Monthlytrans-
actiondepositdata(i.e.non-savings-accountsforcommercial
andretailcustomers)seemtoberelativelyflatoverthepast
13 years. Estimated float revenues generated from those
deposits (i.e. Fed Funds rates) shows the net impact of the
reducinginterestrateenvironment.
These impacts are significant but will be increased through
furtherACHand imagingbasedconversion.Check floathas
beendecreasingasaresultandfurtherproducttransitionand
behavior change is likely to significantly reduce revenue
potential.Analysisoncurrentcollectiontrendssuggestscon-
tinued downward pressure on the collection cycle, further
pressuringfloatopportunityaswell.
162 - The Journal of financial transformation
163
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For monographsJensen,M.,CorporateControlandthePoliticsofFinance.JournalofAppliedCorporateFinance(1991),pp.13-33.
For booksCopeland,T.,T.Koller,andJ.Murrin.Valuation:MeasuringandManagingtheValueofCompanies.JohnWiley&Sons,NewYork,NewYork(1994).
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For periodicalsGriffiths,W.,Judge,G.,1992,‘Testingandestimatinglocationvectorswhentheerrorcovariancematrixisunknown,’JournalofEconometrics54,121-138.
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164 - The Journal of financial transformation
Theworldoffinancehasundergonetremendouschangeinrecentyears.Physicalbarriershavecomedownandorganizationsarefindingithardertomaintaincompetitiveadvantagewithintoday’strulyglobalmarketplace.Thisparadigmshifthasforcedmanagerstoidentifynewwaystomanagetheiroperationsandfinances.Themanagersoftomorrowwill,therefore,needcompletelydifferentskillsetstosucceed.
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Formoreinfo,seepage162
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SEI.New Ways. New Answers.
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Rising costs, heavier regulation, tougher clients in a tougher market – how can a Private Banking business cope?
Can we respond quickly enough to all these changes?
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How do we decide what is best done in house, and what needs to be outsourced?
SEI knows about the competitive benefits of outsourcing in private banking institutions.
To get a copy of SEI’s special report ‘Outsourcing and the European Wealth Management Market’*, call Francis Jackson on + 44 (0)207 297 6308, or Email [email protected]
Hear what the industry is saying.
Four Key Questions for Wealth Managers
* Research amongst CEOs, CFOs and Senior Executives of wealth management institutions in 10 European Countries
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